Will The 25 Bp Cut Be Enough? Will It Be The Last?

The ECB did not surprise markets this week. As widely expected, it cut the refi rate by 25bp to 0.50% a new low, keeping the interest rate on deposit facility (DFR) at 0%. The corridor was reduced to +/- 50bp. Yet the poor state of the economy probably would have justified a bolder action, with a cut of at least 50 bp.

Recently released data confirm that the eurozone patient remains sick. Not only activity kept contracting in the first quarter of the year, but early survey data for the second quarter showed that confidence continued to deteriorate. Levels of leading indicators are quite low by historical standards, suggesting that a return to growth in the short-run is unlikely. More alarmingly, Germany, the main engine of the eurozone, is running out of steam. Domestic demand remains fragile. Countries are proceeding on the necessary process of consolidating public finances. Although the European Commission could adopt a more flexible approach regarding the timing of adjustments, these measures will continue to weigh on domestic demand. Developments in the labour market will not help. The unemployment rate reached a new high in March, a record, likely to be broken again over the coming months. Contracting activity in peripheral countries combined with sluggish growth in core countries jeopardise the ECB’s view that the eurozone might return to growth in the second half of the year.

As regards to prices, the ECB risks overshooting its target. Inflation is well below the 2% ceiling target. In April, it fell to 1.2%, from 1.7% in March and 2% at the beginning of the year. Methodological changes might have added some volatility as did the sharp decline in energy prices, but the slack of the economy is clearly biting. Inflation might partially rebound going forwards. Yet, it is on a downward trend. According to its latest projections (released in early March), the ECB forecasts inflation at 1.3% in 2014. Downside risks to this scenario have probably increased.

BY Clemente DE LUCIA

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