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Wednesday, November 06, 2013

ECB preview – ECB edges towards rate cut as inflation drops

Interest has grown in this month’s ECB meeting, after inflation surprised on the downside last month, falling to 0.7% - far below the ECB’s 2% target.

In all likelihood, the discussion will not be too different from previous monthly meetings, but there are a few points worth flagging up.

A rate cut in November or December?
  • The consensus is now moving towards a rate cut this month, or more likely next month. As we pointed out before, this will have little impact given that rates are completely detached from the ECB’s main interest rate and the transmission mechanism remains broken in much of the eurozone. Ultimately, it is a signal that the ECB is keen to keep loose monetary policy. 
  • The ECB, though, could well hold back for a few reasons. Firstly, it probably wants to see how the nascent recovery in the eurozone develops. Secondly, it knows this is probably its final rate cut and wants to time it correctly. Thirdly, its medium-term forecast is for inflation to recover (although this is likely to be revised downward in December). 
  • FT Alphaville also highlights the interesting point that, given that this will likely signal the end of rate cuts, the response could even be a slight increase in market rates.
A new LTRO in the New Year?
  • The shrinking of the ECB balance sheet continues, as eurozone banks are repaying the LTRO loans. Liquidity is dropping rapidly in the eurozone and short-terms rates have edged up somewhat – creating a de facto tightening of ECB policy. This is exacerbated by the continued easing bias by the other global central banks.
  • That said, the previous LTROs have served to increase the sovereign-banking loop. They also remain a blunt tool since the amount of liquidity injected relies on demand, while the prospect of this lending being stigmatised under next year’s stress tests could discourage banks from tapping it.
Euro strength weighs on the ECB’s mind
  • The strength of the euro in recent weeks, particularly against the dollar, has been covered widely with an increasing number of investors and politicians calling for action on this front. 
  • Although the ECB has stressed that it does not target the exchange rate, it has shown before that it certaintly considers it. Draghi has shown a willingness to ‘talk down the euro’ previously, and is likely to try and do so again. However, turning this into lasting success is tricky and clamour for more concrete signs could increase.
  • Failure to address the issue also leaves the currency open to volatility, as markets struggle to interpret the ECB’s vague signals and balance them with more defined ones from other central banks.
What to do with the deposit rate?
  • This is another aspect weighing on the ECB’s collective mind. As we pointed out before, a cut to negative territory could have many unintended consequences, and is unlikely to be risked in anything but the worst circumstances. Still, the desire to maintain some ‘corridor’ between the regular rate and the deposit rate could make the ECB think twice about cutting rates at all.
As the above suggests though, we stick by our view that the ECB does have limited tools to help promote economic growth. This meeting is also likely to be another test of its new communication policy and whether it can really have lasting market impact. Ultimately, though, pressure for some concrete action from the ECB is likely to increase as long as inflation remains subdued.


Jesper said...

The strength of the euro is an interesting situation. The other main world currency, the USD, is at the moment being debased by the Federal Reserve. The ECB is prohibited by treaty from doing the same. The alternative might be to print euro and instead do what the Swiss has done - print and use the printed money to buy things from outside the currency.

Buying USD seems like a bad idea, buying other currencies might not help much, buying gold also has problems. Germany was told to wait seven years for delivery of gold they owned and that delay can be a cause for concern for anyone considering to buy gold for delivery.

One thing that might cause the EUR to lose value is lack of safe assets. Investors without any safe place to invest in EUR might sell their EUR-denominated assets and buy 'safe' US federal debt. A couple of defaults with losses on items previously seen as safe might do the trick...

Rik said...

You cannot have your cake and eat it. The EU has a trade surplus it is as simple as that.
The same goes for sandwiches btw. Like the ones that want the South getting more competitive by price decreases as well as put upward pressure on inflation for other reasons.

Anyway it (rate stuff) is not working properly. As the rate is already close to zero and the advantages are effectively only passed to the dysfunctional (mainly Southern) government sector. And that is exactly the place where you donot want to new jobs to occur.
Simply mainly keeps dysfunctional states and financial sectores alive at the moment. Reform pressure on the South is reduced to zero. Southern banks are tied to Southern governments that are likely to collapse one way or another.
Highlights again as well that in the South there is no real competition in a healthy financial sector. The Sarko trade is used to brush off the banks' BSs as apparently tie yourself to the Spains of this world is seen as the best option available. And there is no real competition so rates are passed on to all players and not only the government.
Just buying time.

Anyway it will put a lot more pressure on say Finnish and German real estate markets and bubble nicely there. Prices are simply mainly rising because it is the least dirty shirt. Effectively prospects are worse than pre-crisis but prices rise much faster. Nothing to do with fundamentals, so most likely a correction will happen. And when in Germany the bubble burst good luck to all.