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.

Another tricky morning for the eurozone

It’s been a somewhat less than pleasant morning for the eurozone. Firstly, the European Commission put out its latest economic growth forecasts, which do not make great reading for many countries. Here is a comparison between the EC's forecasts and the latest national government forecasts for growth:

As the table shows, there is a long list of countries which seem to be overestimating their growth for this year including: Italy, France, Spain, the Netherlands and Ireland.

We expect to see a series of growth revisions throughout the year on the part of national governments – in some cases such as Greece, we expect that the Commission forecasts will also prove overly optimistic (notably the figures used in the Greek budget are actually below the Commission forecasts). The figures also highlight the growing cracks in the Franco-German axis as the two countries diverge economically; this was reinforced by the starkly different PMI (business activity) figures yesterday.

The implications of these inflated growth projections are also becoming apparent. Nowhere is this clearer than in Spain, where the Commission highlights that, without additional measures, the Spanish government deficit in 2013 and 2014 will be 6.7% and 7.2% of GDP respectively. This compares to targets laid down by the eurozone of 4.5% and 2.8% respectively.

The Commission’s estimates of Greek unemployment also still seem unrealistic, at 27% and 25.7% in 2013 and 2014. In November 2012 unemployment reached 27% in Greece, according to the Greek statistics agency. With plenty of structural reforms still to go we expect this figure to increase further.

Secondly, the announcement of the repayment of the ECB’s second Long Term Refinancing Operation (LTRO) came in significantly lower than expected – 356 banks repaid €61.1bn compared to average expectations of €122.5bn. The steep slide in the euro exemplified the market response.

This highlights that underneath the recent optimism there is still significant fragmentation in financial markets and concerns over liquidity (as we have noted previously). Although impossible to tell conclusively, since these are just aggregate figures, we expect that many of the banks that have repaid were from ‘core’ eurozone countries, further exacerbating the differences between eurozone countries.

If you are looking for a silver lining, it could be that the rise in the euro has been halted for now, which may aid the competitiveness of the weaker countries, and that a potential de facto tightening of monetary policy has been avoided - this could have been a concern if banks repaid the LTRO and deleveraged rather than investing the collateral elsewhere.

The picture emerging from this morning’s data, then, continues to be a bleak one for the eurozone thanks to stalling growth across the bloc and banks hanging onto ECB liquidity. Beyond the headlines though, there is evidence of growing divisions as some of the core countries post growth and their banks repay ECB funding while peripheral countries find themselves in economic decline with banks surviving on ECB money but lending little.