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.

ECB rate rise next year not a done deal

In June, the ECB announced it was likely to end its net asset purchase  programme in December and that it expected to keep interest rates at their present level ‘at least through the summer of 2019‘ , albeit with a caveat relating to inflation developments remaining in line with the Banks expectation of a steady convergence to target. Some confusion ensued as to when the summer actually ends but the ECB has since indicated it is happy enough with market expectations of a rate rise at the September or October meetings next year.

Any change is more likely to initially  involve the  ECB’s Deposit rate rather than the Refinancing rate, and the latter is more significant for existing Irish mortgage holders as Tracker rates account for over 40% of the stock of mortgage loans.However,  it would then  only be a short period of time before a rise in the refinancing rate occurred if the ECB was  set to embark on monetary tightening.

Why has the Governing Council decided to signal a probable rate rise? In part because the EA economy performed strongly in the latter part of 2017 and although growth moderated in the first half of this year, to 0.4% per quarter, that is still above what the Bank considers to be potential, which has resulted in further falls in the unemployment rate. The ECB is also more confident that wages are finally responding to the tighter labour market, and as a result expects underlying inflation to pick up steadily , with the ex food and energy measure forecast to average 1.8% in 2020 from 1.1% this year. As such , the Council is more confident of a ‘sustained convergence’ in headline inflation to target.

In fact headline inflation has been above target for the past four months, oscillating between 2% and 2.1%, boosted by higher energy prices. Yet that is also squeezing household incomes ( wage growth was 1.9% in q2) and core inflation ( which excludes food , energy, alcohol and tobacco ) has remained stubbornly at 1.1% or below in recent months, slipping back to 0.9% in September.

The  economic outlook also looks less robust than it did. The ECB maintains that the risks to EA growth are balanced but at their September meeting  it was noted that a case could be made that the risks had tilted to the downside. Since then , the global outlook certainly seems to have deteriorated amid a backdrop of falling equity markets, rising trade tensions, weaker growth in China, a rising dollar, Brexit uncertainties and  Italy’s apparent willingness to breach euro fiscal rules.

Indeed, some of the hard data in the EA has been noticeably weaker over the summer months and the PMIs have also softened, with the latest reading for the EA as a whole dropping to a 2-year low of 52.7 in October, That is consistent with GDP growth of only 0.2% a quarter and it will be interesting to see whether the ECB reiterates its balanced risk view at the upcoming meeting.

It may be that the current weakness in sentiment and activity proves temporary but what may also concern the ECB is that more forward looking indicators also signal weakness ahead. The major European equity indices are all heavily in the red year to date while monetary indicators are not reassuring; M3  growth has slowed to 3.5% while the growth rate of lending to the private sector has remained becalmed at 3.4% in recent months, with mortgage lending slowing a little to 3.2%.

It is unlikely that the ECB will do a volte- face on its forward guidance at this juncture but the risks to their view on inflation have risen and it is not a done deal that rates will rise in 2019.

What next for the ECB?

The ECB faces some tricky policy decisions  and judging by the minutes of the last meeting the Governing Council has no clear view on how to proceed. The euro zone economy has surprised to the upside this year, bank credit across the zone is  growing again, the redenomination risk in sovereign bond markets has long gone and the unemployment rate has fallen to 9.1% from  a peak of over 12% , all of which  might  argue for a change to policies born in a crisis environment or adopted when deflation was perceived as a real danger.

Yet the ECB”s (self-imposed) goal remains elusive- inflation is not ‘close to but below 2%’ and according to the current staff forecast that will remain the case for some time, with an average of 1.5% projected for 2019. Indeed, according to the minutes, some council members questioned whether the staff had used an appropriate pass-through rate from the euro’s recent appreciation and hence wondered if the inflation forecast was actually too high.

The minutes also revealed ‘discomfort widely expressed’ about the length of time inflation had been and was expected to remain below target, and that ‘a very substantial degree of monetary policy accommodation was still needed for inflation to converge sustainably to levels in line with the Governing Council’s aim’, which would imply that we are unlikely to see a substantial policy shift in the near trem. Indeed, ‘any reassessment of the monetary policy stance should proceed in a very gradual and cautious manner‘.

So what are the options?. Policy as it stands includes the purchase of €60bn assets a month until the end of December this year ‘or beyond, if necessary‘. The minutes would indicate an abrupt halt in  a few months is out of the question but there are logistical issues in a number of countries, given  the current 33% issuer limit on sovereign bonds. Consequently, the market is anticipating some form of ‘tapering’, and the minutes discussed the merits of continuing to buy for  a longer period but at a slower monthly pace against a higher monthly volume over a shorter time frame.

The former is perhaps more likely, as it better ties in with another strand of policy, a commitment to keep interest rates at current levels  for an extended period and ‘well past the horizon of the net asset purchases’. This explicit linking of forward guidance on rates to QE argues for extending the latter for a longer period if the ECB wants to influence rate expectations and that might indeed have an additional impact, this time on the exchange rate. We know the Bank is concerned about the currency’s appreciation, and if one rules out explicitly talking it down one lever left is to convince markets that rates will stay lower for longer.

The ECB will also no doubt emphasise that it intends to keep reinvesting the proceeds of maturing assets but the net asset decision will be key, and lower for longer may well be the mantra that decides the latter.

 

ECB Traversing outer limits of Policy

The ECB has travelled a long way in its thinking over the last few years, and following the latest round of measures is now at the outer limits of monetary policy, with little left in its armoury. Indeed, we may be moving closer to the point where European policy makers decide that putting all the pressure on monetary policy is a mistake, and that fiscal policy has to be more active when faced with a balance sheet recession and its aftermath.

Inflation in the euro area has been below the ECB’s 2% target for some time and Draghi has often emphasized the fragile nature of the limp economic recovery but the past month has seen a much more negative perspective emerge, as crystallised in the Bank’s economic projections; growth is expected to remain below 2% for the next three years and inflation is forecast to rise to just 1.4% in 2016 from 0.7% this year. Deflation is not seen as likely but such a prolonged period of low inflation is seen to carry  the risk that expectations of sub-2% inflation become embedded.

The ECB can only directly influence very short term interest rates ( the market determines longer rates) and Europe depends heavily on bank credit to finance private sector spending ( as opposed to bond financing) so any policy levers are largely dependent on the banking sector as the transmission mechanism, with the added complication that lending rates are much higher in some parts of the zone than others. The Bank tried to address that fragmentation by providing 3-year cash to the banks in late 2011 but over half of that has been repaid and many banks used it to fund the purchase of government debt, with the result that bank lending to non-financial corporations in the euro area is still contracting. That is due in part to the economic cycle ( demand for loans is low) but the ECB has copied the Bank of England’s  Funding for Lending scheme in seeking to influence the supply of credit  via the  provision of  funds aimed directly at the private sector. Under the targeted scheme (TLTRO)   euro area banks can access funds for up to four years, starting in September, at an initial rate of 0.25%, with an initial limit of some €400bn (7% of the outstanding loan stock ex mortgages) implying a figure in excess of €5.5bn for Irish banks given the €78bn outstanding in loans to non-financial firms (the figure could be higher if one includes personal debt ex mortgages). Draghi talked about monitoring the loans but at first site the penalty for not lending to the private sector is early repayment so it is not clear how much of a stick exists alongside the carrot. Further tranches can be drawn down depending on meeting benchmark targets on net credit growth.

The UK scheme did not have a huge impact and  it remains to be seen whether demand for loans will pick up particularly in depressed economies. Banks are also due to repay some €500bn of the remaining 3-year funding although the ECB has also decided to stop sterilizing the bonds purchased under the SMP, meaning it will no longer drain the equivalent amount of money from the system. The buying of private sector debt, via Asset Backed Securities, is also on the cards, although that will take some time to organise and the market there is small.

As noted the ECB can directly affect short rates and it cut the main refinancing rate by 10 basis points to 0.15%, which  will bring some modest gains to anyone on  a tracker loan and to banks borrowing from the ECB. Lower rates may also put some downward pressure on the currency on the FX markets and to aid in that the ECB cut its deposit rate to negative territory (-0.1%) and will supply as much short term liquidity as banks demand at a fixed rate out till the end of 2016. This puts some flesh on the pledge to keep rates at current levels for an extended period and seeks to influence longer term rates in the market. The euro had weakened in the weeks before the ECB meeting in early June as traders built up  short positions in anticipation of negative rates, but has not fallen further, at least as yet, highlighting that measures that are seen to reduce fragmentation in the euro area often serve to bolster the currency.

The forward guidance issued by the ECB also now excludes any reference to even lower rates and Draghi explicitly stated that we are at the end of the line in terms of rate reductions. Consequently, the  main weapon the ECB has left is full QE, but that is unlikely to have much affect on euro domestic demand given the importance of banking credit. Hence the TLTRO but if that does not work ( and it will take some time anyway for any impact to be felt) the conclusion has to be that fiscal policy may be revisited, with the current conventional wisdom on the need for debt reduction overturned in favour of fiscal expansion. That may be a long shot now but who would have predicted  a few year ago an ECB Funding for Lending scheme, forward guidance and a refinancing rate of 0.15%?