ECB rates lower for longer , Redux

Last June the ECB had grown more confident that the ongoing economic upturn would eventually result in inflation rising to nearer their target and at that month’s press conference announced that net asset purchases would ease and eventually cease at the end of the year. The Governing Council also made a significant change to its forward guidance on interest rates, which were now expected to remain at existing levels until ‘through the summer of 2019’, so replacing the previous ‘extended period’ with a more specific date for the first upward move.

At the time headline inflation had risen to 1.9%, with the ex-food and energy measure at 1.3%. Euro area growth was  expected to moderate only marginally, to 1.9% in 2019,  so the idea that the monetary policy stance was likely to change seemed plausible, and the markets duly priced in a 10bp increase in the deposit rate  for around September 2019.

Events did not materialise as the ECB expected, however. Growth in the EA slowed to 0.2% in the third quarter, with Germany and Italy both experiencing contractions, and the high frequency data implies that the fourth quarter figure could be weaker still. Consequently, the annual growth rate in q4 may well slow to 1.1% and initial indications from the January PMIs imply an annual figure of well below 1% in the first quarter, which makes the Bank’s 1.7% average growth forecast for 2019 look very optimistic. Inflation, too, has disappointed the ECB, with the ex food and energy rate seemingly anchored at 1.1%, with a core figure of 1%.

Some observers, including many on the Governing Council, had expected the slowdown that emerged in the second half of 2018 to be short-lived, particularly as the US economy is still growing strongly, albeit at a less dynamic pace than earlier in the past year. It now appears that others on the Council have become more concerned that the slowdown could be more protracted, and at the latest  ECB press conference the risks to the outlook were now deemed to be on the downside. Indeed, Draghi actually used the term ‘recession’, albeit giving it a low probability.

The ECB prefers to announce policy changes against the backdrop of a fresh set of forecasts, and so it chose to leave its current forward guidance on rates unchanged. That ‘summer of 2019’ guide now looks redundant, however, at least as far as the market is concerned, with the first rate rise now pushed out to around June 2020.  Longer term rates have also fallen, with 10-year Bund yields back below 0.2%, while  the cost to a commercial bank with a good  credit rating of borrowing three year money is -7 basis points. The euro has also faltered , and is trading back below 87 pence sterling. In fact Draghi acknowedged the divergence and implied that the Bank might well have to change its guidance at the March meeting, when of course it will have an updated set of staff forecasts.

There is still an enormous amount of excess liquidity in the euro system (around €1,800bn) but there is also some speculation that the ECB may announce a further TLTRO, which  was introduced in 2016 and is currently providing over €700bn in long term funding to euro banks at negative or zero rates, with a high uptake from  Italian and Spanish banks. For a number of reasons a substantial repayment may take place in June, prompting talk of an additional tranche to maintain high liquidity levels.

The economic outlook can change, of course, and a combination of a managed Brexit alongside an easing of trade tensions could spark an upturn in activity, hence prompting a change in rate expectations. The ECB also seem more concerned than in the past about the impact of negative rates on bank margins, another argument for moving rates up. Against that, the data flow remains relentlessly negative and there must be a risk that the ECB may have to change stance again, and adopt  additional measures to support activity. A generalised slowdown or recession would also probably prompt a big EU rethink on the fiscal side as monetary policy has taken most if not all of the strain in recent years.