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.