ECB caught between strong growth and weak inflation

Longer term euro interest rates have moved higher over the past few weeks as the market starts to adjust to what it perceives as an imminent change in monetary policy from the ECB. 10-year German bond yields are trading at over 0.5%, which is still extraordinarly low but compares with a yield of only 0.25% at end-June, so the speed of the move has surprised. A  ‘reflation’ reference by Draghi was the initial  catalyst ( although later played down by the ECB)  and the pace of economic activity has  certainly picked up this year but the problem for the hawks in the Governing Council is that inflation remains stubbornly below target (1.3% in June), with the core rate still remarkably low (1.1%).

GDP in the Euro area  (EA) grew by 0.6% in the first quarter and  strong  survey readings  (the IFO in Germany is currently at  a record high) imply a similar if not stronger figure for q2. On that basis it now seems likely that annual growth in the  EA may emerge at 2.1% or 2.2% this year and hence above the 1.9%  projected in the June  ECB staff forecast. There have only been two previous tightening cycles by the Bank, and the IFO is currently well above the level that has previously triggered higher rates, but , to date, the pick up in economic activity has not put any material upward pressure on prices.

The persistence of low inflation , not just in the EA  but across  other developed economies, notably the US, has prompted a lot of analysis.What is striking is the behaviour of wages, as they have not responded to tightening labour markets in the expected way. That relationship is generally known as the Phillips curve, and the evidence shows that the curve is now much flatter than in the past i.e.  a given fall in unemployment has very little impact on wages. So, for example, EA unemployment has fallen from 12.1% to the current 9.3% but wage inflation in q1 was only 1.4% and averaged 1.5% in 2016.

A range of factors have been put forward for this limp growth is wages; low price inflation, the decline of trade unions, globalisation, the growth of self employment and changes in the structure of the jobs market. Many of these factors are structural and if so, the acceleration in wage inflation expected by the ECB over the next few years may not materialise, despite stronger GDP growth.

The ECB also now tends to emphasise core inflation more than it did under the previous President, but the inflation target is set in terms of the headline rate, and most research shows that to be strongly influenced in the shorter term by commodity prices and the exchange rate. Consequently, the recent fall in oil prices and the appreciation of the euro ( up 8% against the US dollar in the past three months), unless reversed, would normally prompt a further downward revision  in the the next ECB inflation forecast in September.The June forecast itself reduced the inflation projection over the next three years by a cumulative 0.6 percentage points, largely reflecting weaker oil prices. Another point worth noting is that credit growth, although stronger than last year, is still anaemic, a factor referred to in the latest ECB minutes.

So what is the market expecting? It would be difficult for the ECB to claim that there are upside risks to inflation but having stated that the risks of deflation have effectively disappeared the Bank may tweak it guidance on asset purchases, which currently states that ‘we stand  ready to increase our asset purchase programme in terms of size and/or duration‘. In reality, the scope to increase QE is anyway constrained, as in a number of cases the Bank is at or close to the 33% issuer  limit in government bonds. However, the market does not expect an immediate halt to buying by the end of the year, rather a  gradual tapering of the monthly total into 2018.

Yet the ECB would find itself in a difficult situation if inflation fell further over the next few months, as it has argued that QE has been instrumental in boosting the price level and that ‘ a very substantial degree of monetary accommodation is still needed for underlying inflation pressures to build up and support headline inflation in the medium term’. The Fed  also faces low inflation but can point to its dual mandate ( stable prices and full employment ) to justify tightening,  but the ECB does not have that luxury.

Stronger euro and weaker oil bad news for ECB hawks

Last December the euro briefly traded below 1.04 against the US dollar and few forecasters envisaged a short term recovery, with a number calling for parity against the greenback. In the event the euro has appreciated, with the past two months seeing a notable rally, taking the single currency above $1.12. The consensus has also shifted, with many abandoning bearish calls in favour of further euro appreciation. Speculative positioning  has also tilted decisively, with the market now running modestly long the euro/dollar for the first time in over three years.

One factor driving the euro is the economic data, which has generally surprised to the upside,  in turn prompting analysts to revise up their GDP projections. As a consequence many now expect the ECB to shift its policy stance, moving initially towards less dovish rhetoric before changing its forward guidance, although a rise in the deposit rate is not fully priced in until the latter part of 2018. In contrast, the US data has tended to surprise to the downside and the market, which was effectively pricing in two further rate hikes in the US this year, is now much less confident about the second ( although  a rise this month is still seen as highly likely)

In its  Staff forecast in March the ECB projected inflation at 1.7% in 2019, predicated on a euro/dollar rate of $1.07 over the forecast horizon. The exchange rate is seen to have a significant impact on prices in the EA and if the next forecast ( due later this week) used a rate of $1.12 that , all else equal, may push the inflation forecast for 2019 down by as much as 0.2 percentage points.

Moreover, the March forecast assumed an oil price around $56 over the next few years, and that now looks too high, given developments of late , with  Brent crude prices falling to around $50 on market concerns that the OPEC cuts have not been sufficient to make an appreciable dent in the unusually high level of crude stocks. Again, a lower oil price projection, say around $50, would shave up to another 0.2 percentage points off the inflation projection.

Of course the Staff may revise up some other components ( wage growth for example) to avoid having to lower the inflation outlook, and one sometimes wonders if the forecast drives ECB policy or the other way round, but on the face of it the combination of weaker oil and a stronger currency should have a disinflationary impact.


Euro rate rise expectations overdone

Just over a year ago the ECB cut its main refinancing rate to zero and its deposit rate to -0.4%, having first shifted the latter into negative territory in June 2014. As a result money market rates have also been negative for some time while longer dated  rates only turn positive at a maturity above 3 years. Yet March saw a change in the market view with regard to the ECB’s monetary policy and the possible timing of an interest rate rise, reflecting  both incoming data and  what were perceived as less dovish comments from Frankfurt.

The  euro composite PMI has  certainly continued to strengthen, reaching a six-year high in March,  and points to 0.6% rise in GDP in the first quarter given the past relationship between the two series, with the prospect of even stronger growth in q2. That, in turn, would point to a significant  upward revison to the current consensus growth  forecast for 2017 of 1.7%. Headline inflation also surprised to the upside, reaching 2% in February,  slighly above the ECB’s target.

The market also reacted to President Draghi’s comments that the ‘risks  of deflation have largely disappeared‘. The Governing Council still expects rates to remain ‘at present or lower levels for an extended period’  but Draghi also said that there was a ‘cursory’ discussion  at the March policy meeting about removing the prospect of a further rate cut while also stating that no Council member favoured any additional long term lending to the banking system . The market responded by giving a much higher probability  of a 0.1% rise in the deposit rate  this year and certainly by mid-2018.

The  ECB later let it be known that it felt the reaction excessive relative to the message it was seeking to deliver and rate rise expectations have been pared back somewhat, with a rise of 0.05% priced in by March 2018. The data has also been less suppotive and indeed worrisome for the ECB. The flash estimate for March inflation was much lower than expected, at 1.5%, and if one excludes food and energy the rate fell back to cycle low of 0.7%. Moreover, the modest uptick in credit growth that had been apparent appears to have stalled, with the annual rise in loans to the private sector easing in February, to 2.3%. These figures  impacted the euro, which is now trading back at $1.065 having spiked to over $1.08. The ECB also puts some store on the 5 yr 5 yr inflation swap as a measure of inflation expectations ( albeit less so now than in the past) and that has fallen back below 1.6%.

Some claim the March inflation data owes a lot to the timing of Easter ( in March last year ) and that there will be a seasonal rebound in April, including the core measures.  Unemployment in the euro area is also falling steadily, which might be expected to push up wage inflation ( although the latter has continually disappointed  forecasters) and that view is reflected in ECB projections, which envisage core inflation picking up to average 1.8% in 2019.

On market rates themselves, the level of excess liquidity ensures that short rates do not stray too far from the deposit rate , which is -0.4%. That excess, which tops €1,500bn, is the amount the ECB is pumping into the banking system, via QE and the TLTRO, over and above the liquidity  banks need to meet normal requirements. The Governing Council hopes this will be used to boost bank lending but so far the impact is limited, and one wonders what the ECB would do if credit growth slows in a material way. That issue may not arise but unless core inflation picks up appreciably any rate rise speculation is premature.


Can the ECB do any more?

Inflation in the euro area has been below 2% now for over three and a half years, and the ECB is currently pulling four policy levers in an attempt to get inflation back up to its target level. The first is forward guidance, adopted  by the Governing Council in mid-2013, designed to convince the market that rates will stay lower for longer. The latest wording to that effect states that ‘we continue to expect [rates] to remain at present or lower levels for an extended period of time’ which also flags the possibility of further easing.

In the past the ECB has used official interest rates as its main policy instrument and they are now at historically low levels; the refinancing rate is zero while the deposit rate has been cut to -0.4%. Money market rates are also  negative , including 12-month euribor. Forward rates imply that the market does not expect any upward move in official rates till 2019.

Credit in the euro zone is largely driven by the banking sector ( unlike the US, for example)  and the ECB has also introduced additional measures to boost bank lending , including offering banks long term loans at very low rates. The latest variant (TLTRO II) offers loans up to four years at a zero rate, and banks can reduce the rate paid into negative territory depending on the growth of their loan book. So the ECB would effectively be paying banks to take funds.

Bank lending to the private sector has picked up but is still very weak by historical standards ( the annual increase is currently 1.7%) and so the ECB has sought to influence spending more directly by its asset purchase programme, the fourth policy instrument currently at play. The current plan is to purchase €80bn a month ‘until the end of March 2017, or beyond, if necessary, and in any case until the Governing Council sees a sustained adjustment in the path of inflation consistent with its inflation aim

Inflation is currently 0.4% and the ECB’s staff forecast envisages a gradual acceleration to an average 1.6% in 2018. The consensus market view is that further monetary easing is a virtual certainty, although there is some disagreement about the form that might take. It is noticeable that the Governing Council is now expressing more concern about the profitability of the banking system (at least in the minutes of recent meetings) and fewer analysts now expect a further rate reduction in either the refinancing rate or the deposit rate. It is early days yet for the TRLTRO so any change there is unlikely and so we are left with possible tweaks to QE, including a tapering, although, again, there are a variety of views. Some believe that the ECB may broaden the universe of assets purchased, but in reality that means buying bank debt and/or equities, which may be acceptable for the Bank of Japan but is  highly unlikely , one would think , given the ECB’s constitutional  and operational constraints.

That leaves changes to the current government bond programme, and a majority of analyts believe that the scheme will be extended beyond March, for 6 months or longer. That is not without its problems, however, as in some cases the ECB is at or close to the current 33% issue and issuer limits ( including Ireland) and at various points of late almost half  the available bonds have been trading below zero, with a smaller proportion below -0.4% in yield. A decision to leave the deposit rate unchanged would presumably preclude the latter  and a decision to up the issue and issuer  limits  could potentially give the ECB the main role in any default proceedings, an awkward position for a bank regulator. At the moment the bond purchases are also constrained by the need to adhere to the capital key ( purchases are broadly proportional to each country’s weighting in the ECB’s capital) and again a decision to abandon this may prompt opposition fror the ‘German school’ within the Governing council.

What we do know is that various committess have been set up within the ECB to tease out these matters and examine how QE could be extended if required, but the bigger issue is whether the ECB is at or near the end of its monetary policy cycle. The December Staff forecasts will be crucial and it is worth noting that oil prices are  now higher , which of itself could push the 2018 inflation forecasts to around 2%. The Council also believes its policies have had a significant effect already are are still working through the system. QE has to end at some point, one would think, and the main issue now  is whether it will be in five months or ten.

Draghi as Sisyphus

Inflation in the euro zone has been below 2% for three and a half years now  and under 1% for almost two years, with the latest figure for August at 0.2%. Many people would think this a good thing in a period of very modest wage growth, as it supports real incomes, but it is a failure for the ECB , as its goal is price stability, which it defines as inflation  close to but below 2%. Very low inflation risks deflation in the Bank’s view and although the inflation trend is heavily influenced by weak commodity prices core measures are also weak: excluding food and energy,  inflation was 0.8% in August, indicating very little price pressures.

The ECB was slower than other Central Banks in cutting interest rates but the main refinancing rate is now at zero alongside a negative deposit rate of -0.4%, all designed to encourage banks to lend into the real economy. That approach reflects the importance of banks in the EA as the main providers of credit and the ECB has recently gone further down that particular road, with its  latest TLTRO scheme, allowing participating banks  to access  four-year funds at an interest rate which could fall to the -0.4% deposit rate depending  on lending growth. In other words the ECB could end up effectively paying some banks to lend money.

The ECB also decided to by-pass the banking route by embracing QE, with the purchase of government and corporate bonds designed to push down longer term rates. To date , some €1,165bn assets have been purchased, including over €940bn in government bonds, with the programme currently projected to run until March 2017.

Has any of this worked? Growth in the EA is averaging  around 0.4% per quarter, hardly stellar, but sufficient to put downward pressure on the unemployment rate, which has fallen to 10.1% from a peak over 12%. Bank credit has also started to rise, from a very weak base, with  lending to the private sector growing at an annual 1.7% rate in July and the ECB has been keen to point out that the cost of funds for EA banks in general has fallen steadily as a result of monetary policy decisions.

Yet credit growth is still contracting in many countries, including Ireland, despite ample liquidity. Indeed, data from the Central Bank here shows that in July deposits in Irish banks exceeded loans, a far cry from the 190% loan to deposit ratio seen pre-crisis. This highlights that in some countries deleveraging is still a dominant force and there are other factors at work, including capital issues for some banks, the scale of non-performing loans and the appetite from lending institutions to take on risk.

Negative rates are also an issue, in that they are putting downward pressure on net interest margins; banks are reluctant to cut deposit rates below zero but many of their loans are linked to market rates, which are falling. Initially the ECB was loathe to accept this point, arguing that higher loan growth would be an offset, but in the  minutes of the last Council meeting there was concern expressed  about the profitability of EA banks and their low stock market valuations, increasing the cost of capital for banks and hence reducing lending.

These concerns may dissuade the ECB from further cuts in the deposit rate and they also face problems with QE, in that the universe of government bonds available for purchase is shrinking, and in some cases the 33% issuer limit is likely to become a binding constraint- that will be the case in Ireland, for example. The ECB could change that limit or extend its purchase of corporate debt, although the latter already moves the Bank into allocating credit directly, which may make some Council members uncomfortable as well as stretching its mandate..

The bigger question is whether all this is having any impact on inflation and the answer would appear to be in the negative. Rather than increasing the bet, the ECB might reconsider its whole approach, with a growing  number of policymakers across the globe examining the case for more expansionary fiscal policy. On that point it was notable that the Fiscal theory of the Price Level got an airing at the recent Jackson Hole gathering, with a paper delivered by Princeton’s Christopher Sims, who is closely associate with that approach. The theory is that the price level is influenced by fiscal policy as  well as monetary policy, and argues that low interest rates  can be deflationary , in that they reduce debt service for governments and unless offset by higher spending or tax reductions will result in contractionary fiscal policy.

Generating inflation in the current environment requires much more expansionary fiscal policy, it is argued, and we may indeed end up with a changed fiscal approach in some countries, including the UK, albeit for different reasons. That appears very unlikely in the EA however, and President Draghi may end up like the legendary Greek king, doomed to push a boulder up the hill only to see it always roll back.



Negative Deposit rate hitting profitability of euro banks.

The ECB first cut its deposit rate to negative territory in June 2014, to -0.1%, and reduced it again late that year, to -0.2%, with a third cut taking it to -0.3% in December 2015. A further reduction was announced last month, to -0.4%, and since then criticism of the move has intensified, most notably of late from the German Finance Minister, concerned at the low return for savers.  Low and negative bond yields are putting pressure on insurance companies with products offering a guaranteed return and  the ECB’s deposit rate is particularly irksome for  the hundreds of small savings banks across the Federal Republic, given that retail deposit rates cannot fall below zero.

That squeeze on margins is not an exclusive German phenomenon, of course, and any banking system with a high dependency on retail deposits will be affected. Ironically, perhaps, banks in general have been urged to reduce their dependence on  the wholesale markets , and new Basel III rules on liquidity and funding also push banks towards deposits.

The ECB has recently responded to the criticism  by arguing that any squeeze on net interest margin  can be more than offset by higher loan growth, which the policy is designed to stimulate, and the capital gains resulting from the fall in bond yields. In that context the results of the latest  ECB Bank Lending Survey (BLS) for April is instructive, as it includes a number of ad hoc questions regarding the impact of non-standard monetary policy, including the effect of  the  negative  deposit rate. Not one  bank felt the deposit rate had a positive impact on their net interest income, with 63% stating a negative impact and another 18% a very negative effect, giving a net negative figure of 81%. Asked about the next six months, the net negative figure climbed to 85%. The vast majority of banks had seen no impact on loan volumes, although there was a small net positive, but this was offset by the negative impact on margins, so reducing overall income.

The survey also asked respondents about the impact of the ECB’s asset purchase programme, and again the results are unlikely to raise too much cheer in Frankfurt. A  small net number of banks (4%) had sold sovereign bonds as a result of QE and those experiencing capital gains in general  on assets for sales was a net positive 12% but that benefit was also more than offset by the net interest margin impact, with a net 27% seeing a fall in NIM. The result was that only 9% of banks had seen profitability rise as a result of QE, with 28% experiencing a profit fall, leaving a net decline percentage of 19%.

On the positive side QE was seen to have  improved the liquidity position of banks and  access to financing, notably via covered bonds, and the ECB has of late highlighted these metrics as a sign that  non-standard measures are working. Credit to the private sector is also finally growing again, albeit by an annual 0.9% , but for the moment at least the evidence supports the view that negative rates, in particular, are having a detrimental  effect on bank profits. It remains to be seen how that will change when the ECB’s long term loan scheme comes on stream.




The ECB’s Scattergun

The provision of credit in the Euro Area (EA) is largely delivered through the banking system, in contrast to the US, where capital markets are the main source of  loans. That explains, to some degree, why the ECB sought to flood the banking sector with liquidity following the financial crash in 2008, as opposed to seeking to influence the real economy more directly via the purchase of assets (QE). The Bank has  subsequently travelled a long way in its quest to boost economic activity  and is now utilizing a plethora of instruments in an attempt to hit its inflation target , although this scattergun approach may yield further disappointment.

In June 2014 the ECB was still of a mind that bank funding costs were the problem and announced a Targeted Long Term Refinancing Operation (TLTRO). Banks could borrow up to 7% of their existing loan book (defined as  lending to the non-financial private sector excluding mortgages) in two tranches, in September and December, at a cost equal to the refinancing rate (at that time 0.15%) plus 10 basis points. Banks could borrow more in subsequent quarterly tranches if their lending grew above stated benchmarks, with all lending to be repaid by September 2018.. In the event the take-up was disappointing, amounting to €212bn in the first two tranches , rising to a cumulative €418bn by end-2015, with the take-up in December just €18bn. This compares with total outstanding loans to the private sector of €10,600bn. The funding could not be used for mortgage lending and banks were no doubt influenced by the fact that loans had to be repaid early (by June 2016) if the benchmarks were not being met.

The ECB effectively accepted that the first TLTRO was not a success by announcing TLTRO II last week,allowing banks to repay early existing loans under the first scheme to encourage a switch into the new variant. This one  is designed to boost ‘lending’ as opposed to ‘lending to the real economy’ and there does not appear to be any restrictions. The scheme will start in June, with four quarterly tranches up to March 2017, and loans mature in four years from the time of origination, Banks this time can borrow up to 30% of their non-mortgage loan book at the refinancing rate , which is currently zero. Moreover, banks that are growing their loan book can borrow at a lower rate, down to the deposit rate, which is currently -0.4%. The pool of existing loans amounts to €5,600bn so in theory the amount of TLTRO borrowing could be substantial, with a 60% take-up implying a figure of €1,000bn.

So the ECB has sought to offset the impact of a negative deposit rate on the profitability of the banking system by allowing banks to borrow at that rate, or at least some of them. But is weak lending a function of funding costs?. The answer is probably no, at least for many banks; market rates have tumbled, allowing banks to borrow at very low rates anyway, without tying up collateral for years at the ECB, with capital , profitability and risk aversion the key issues on the supply side of the credit market. Others would argue that the demand for credit is weak anyway, given the uncertain economic outlook, and that the ECB’s decision to cut the deposit rate deeper into negative territory reinforces that uncertainty rather than assuaging it. Deleveraging is also a factor, particularly in Ireland, with many households and firms preferring to repay rather than add to debt.

The ECB has also partially undermined the rationale for the TLTRO by announcing the decision to extend its asset purchase scheme to corporate bonds . This will presumably encourage firms to issue debt and so disintermediate the banking system. Purchases will only include investment grade debt. which also implies that many corporates in the periphery of the euro zone will be excluded, with bank borrowing their only option. So bank lending to low risk corporates may fall, raising the risk profile of any remaining bank lending.

The ECB may also have hoped that’s this suite of measures would help to push the euro down, but that has not transpired, at least for the moment, partly due to  Mario Draghi’s comment that  ‘we don’t anticipate that it will be necessary to reduce rates further’. In that context it is interesting that Peter Praet, a member of the Executive Board, has subsequently sought to emphasize that we are not yet at the lower bound on rates, an indication that the Bank was not happy that the euro appreciated post- conference.


Negative rates are a mistake

The next ECB policy meeting is scheduled for March 10th, and the market is expecting further monetary easing. This was flagged in January , when it was announced that the Governing Council would ‘review and possibly reconsider the policy stance‘  given that downside risks had risen. The minutes  show that some Council members favoured  immediate action but the consensus was to await the publication of the quarterly macroeconomic forecasts, incorporating projections out to 2018. The current forecasts envisage inflation rising from 1.0% this year to 1.6% next, but are predicated on an oil price of $52 a barrel in 2016, which looks untenable in the absence of a seismic shift in global oil supply. Headline inflation had turned positive again in late 2015 and rose to 0.3% in January but the flash reading for February was surprisingly weak, at -0.2%, with  core inflation also slowing to 0.7%.

Euro bond yields have fallen and the euro has depreciated of late in anticipation of ECB action, but the Bank has been cautious in terms of inflating expectations, mindful of the market reaction to its December announcements, which were deemed disappointing relative to what Mario Draghi was interpreted as signaling. The euro’s effective exchange rate subsequently appreciated , rising by 6% to mid-February, and speculative short positions in the euro/ dollar fell sharply. Of course there were other factors at work, including changing expectations about US monetary policy, but it is noteworthy that the ECB minutes warned against raising ‘undue or excessive expectations about policy action’ given what had happened in December.

What can the ECB do?. One option is to reduce the Deposit rate further into negative territory, as other central banks have done, The rate, currently -0.3%, is paid on overnight deposits at the ECB and  the idea is that  banks will be encouraged to lend to other banks or to use these reserves to support lending to the private sector, rather than face losses by continuing to park it with the ECB. A cut in the deposit rate, it is  also argued, will put further downward pressure on money market rates and bond yields, so precipitating a fall in the currency, which would in turn help to boost inflation.

Yet rates paid by banks to depositors are unlikely to turn negative and many loans are based on money market rates, such as 3 or 6- month euribor. Consequently negative rates hit bank margins and hence profitability. Some argue , including ECB Board Members, that this can be offset by strong lending growth but that is certainly not happening in the euro area, with the annual growth in loans to the private sector at just 0.6% in January . Consumers and firms in many countries are still reducing their debt levels (including Ireland, where net credit has been contracting now for 6 years) and on the supply side banks are building capital to meet changed regulatory requirements and are saddled with high  levels  of non-performing loans. Moreover, lending to consumers or businesses is risky and requires higher capital cover than lending to governments , where zero capital is required, particularly when the ECB is in the market buying government debt. The general public may feel that bank profitability is the least of their concerns but a healthier bank system is required if the euro area is to see stronger economic growth and negative rates will not help.

Moreover, negative rates send the signal that economic conditions are far from normal and may exacerbate the perception that monetary policy has indeed reached its limits, and may now be adding to problems rather than easing them. It is also not a given that a further rate cut by the ECB will lead to a sharp depreciation in the euro- witness the recent rally in the Yen following the bank of Japan’s move into negative rate territory- and the euro area’s huge current account surplus means capital outflows have to be enormous to push the currency lower on a sustained basis.

Conceptually, negative deposit rates, if expected to last a long time, could  also lead to a fundamental change in the financial system. Rates on cash are not negative ( excluding some storage costs ) so banks may decide to hold excess reserves in cash rather than deposit them with the central bank. Similarly, retail depositors would have an incentive to do the same thing if commercial banks sought to introduce negative deposit rates on a large scale, so threatening the main function of the banking system, the intermediation of savers and borrowers.

In sum, negative rates are not the answer and symptomatic of a refusal by central banks to accept that the emperor no longer has any clothes. Time  for Governments to take advantage of historically low or even negative bond yields and fund some sensible capital spending , which would boost demand in the short term and support higher growth further out.


Negative repo rate at the ECB?

Economic growth in the euro area (EA) has been trundling along at 0.4% per quarter, which is probably above the zone’s potential rate but has not been strong enough to put much upward pressure on prices; core inflation is likely to average under 1% in 2015 and although some acceleration is generally expected  over the next few years it is forecast to be modest. The ECB’s inflation target is set in terms of headline inflation, which is currently lower still, at around zero, and again that is expected to pick up, reflecting the unwinding of the recent falls in commodity prices, but few if any forecast a rebound to 2% or above  by end-2017.

Low or zero inflation is supportive of real household incomes given the modest pace of wage growth ( 1.9% in the EA in q2  and 1.8% in Ireland) but the ECB is concerned about a prolonged period of below-target inflation, not least in terms of its own credibility. A more fundamental reason is that the real rate of interest (the nominal rate minus expected inflation) rises if expected  inflation falls, which all else equal will dampen investment spending in the economy.

Those concerns have prompted the Governing Council to contemplate further monetary easing, including additional non-standard measures such as an expansion of QE. The latter has  helped to boost asset prices in the EA and lowered corporate and bond yields, according to the ECB,  but it is less clear what impact that has on inflation- the effect on demand in the economy may not be large enough to put significant upward pressure on prices. QE is also deemed to weaken the currency and the euro certainly fell sharply in the early months of 2015, declining by 11% in effective terms to mid-April. According to   the ECB’s models, a 5% depreciation could boost inflation by up  to 0.5 percentage points so a currency depreciation would  seem to have the biggest impact on prices.

The euro reversed course over the summer months, however, rising by  7% in the four months to end-August , but has started to fall again and is currently about 7% below its value a year ago, albeit still 2.5% above its April lows. This also reflects  the expectation of rising rates in the US but the ECB may well seek to precipitate a much steeper fall in the effective exchange rate.

To that end the ECB has flagged a possible  cut in its Deposit rate, which for over a year has been at -0.2%. Despite that, deposits at the ECB, which had been very low at the beginning of the year, have risen strongly of late and currently stand at €187bn i.e. banks  would prefer to pay to leave cash at the ECB rather than lend it to their peers. Draghi had previously indicated that rates had reached the effective lower bound but that may be reassessed, not least because the deposit rate is at -0.75% in Switzerland and Sweden. Consequently, any  Deposit rate cut in early December may be larger than the modest change generally expected and a rate of -0.5% could be on the cards, which would also increase the universe of bonds eligible for QE.  Similarly, the refinancing rate could also move to zero or even marginally negative (the Swedish reo rate is -0.35%) if the ECB wants to surprise the markets and engineer a more substantial fall in the exchange rate.


Euro and Oil price likely to prompt ECB action

The Euro Area has experienced economic growth for eight consecutive quarters and the pace of expansion this year is likely to average around 1.6% from 0.9% last year.  Most forecasters, including the ECB, expect that pace of growth,  of around 0.4% a quarter, to continue into next year and alongside  rising oil prices is projected to lead to a pick up in inflation , to 1.1% in 2016 and 1.7% the following year, and as such nearer the  target level. Recent developments in the exchange rate and the oil price may prompt a forecast revision, however, and the ECB has just flagged that it may take further policy action in December, contingent upon an updated inflation forecast.

Headline inflation. which had been negative early in 2015, turned positive in the Spring but has weakened again of late, with September recording another negative number (-0.1%). Energy prices fell by 1.7% in the month and are down some 9% on an annual basis, which  of itself reduces the overall inflation rate by 1 percentage point. Core inflation is also weak, however; prices rose by just 0.9% if one excludes food and energy while inflation in  services, which accounts for over 40% of the index, is just 1.2%.

The current ECB forecast is predicated on a rise in oil prices to an average of $56 a barrel next year, but this now looks too high; the current forward price of Brent implies a figure around $52. Moreover, the ECB expects the euro to average $1.10 , and as such are clearly concerned about the currency’s recent performance, with a 7.5% appreciation against the dollar since the Spring, taking it above $1.13 from below $1.06, and a 6.5% rise in the trade weighted exchange rate. Consequently, the forecast price of oil in euro terms of €51 now looks wrong on two counts, and may be closer to €46 in the December forecast in the absence of a significant fall in the euro on the FX markets.

Engineering such a fall may be difficult in the absence of stronger US data and a tightening of monetary policy by the Fed but the ECB is likely to take some measures. President Draghi took a step in that  direction at today’s press conference by opening the possibility of a cut in the rate the ECB pays for overnight deposits from the banking system. The Deposit rate was cut to -0.2%  over a year ago and Draghi had indicated that it was at the effective lower bound but that may no longer be the case, judging by his latest remarks.

Apart from a Deposit rate cut the ECB has also indicated that it will use other instruments to ease policy further if deemed necessary. The simplest. and most likely, is an expansion of the current asset purchase scheme , which could take the form of a higher volume of monthly purchases , a broadening of the assets deemed eligible or a prolongation of the time frame of the programme.

It may well be that we are at the effective limits of monetary policy, and further QE may be both ineffective and political troublesome for the ECB, as it carries implications for income distribution. Some council members have talked about the need for non-policy measures and it may well be that the whole fiscal policy debate will be reopened but for now the ECB remains the only game in town.