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Article / 31 March 2014 at 15:03 GMT

ECB room for manoeuvre capped despite growing disinflation threat

Blogger / MoreLiver's Daily
Finland

• ECB unlikely to cut rates in response to disinflation threat
• ECB range of policy options limited
• Cyprus, Greece, Slovakia, Portugal, Spain in deflation

The European Central Bank's (ECB) meeting on Thursday will face additional pressure from the worsening inflation outlook. Still, inaction is always a good bet when it comes to the ECB.

Inflation falls to 0.5 percent, several countries in deflation

The European statistics agency Eurostat published today the flash estimate of the harmonized index of consumer prices (HICP) for the euro area. The HICP showed the inflation rate has continued falling, and was 0.5 percent in March, down from 0.7 percent in February. While consensus was expecting a smaller drop to 0.6 percent, the latest estimates were already eyeing 0.5 percent, so the market reaction was muted.

Based on country-level data, Cyprus, Greece, Slovakia, Portugal and Spain are now officially in deflation, and as more detailed data will become available and especially if the trend holds, several other countries could join the crowd.

 HICP
Source: Saxo Bank

Pressure to act, but enough excuses not to

As we move further away from the ECB’s two-percent inflation target, one would normally assume any central bank worth its salt to begin acting in a very vocal manner.

Europe is different, and the ECB has chosen to focus on other variables. The low HICP-reading in March can partly be explained by calendar effects. The purchasing manager indices in Europe are still pointing to growth, and the latest monetary developments report showed that money supply growth and bank lending show some signs of stabilisation. The ECB’s macroeconomic projections show inflation returning to more comfortable levels in the distant future. Frances Coppola posted a stunning picture on her article in Forbes, showing how the ECB has adjusted its inflation forecasts to show steeper increases in the future while the realised inflation has fallen.

 EZ select data
Source: Saxo Bank

ECB forecast

Built-up expectations redux

The situation is somewhat similar to last month’s meeting. On March 6, the ECB decided not to stop sterilisation of its bond purchase programme, even though both ECB president Mario Draghi and the German central bank Bundesbank had previously indicated that such a move would be feasible and desirable. During the press conference Draghi explained that ending SMP-sterilisation would be only a short-term measure and would only add liquidity for a period of roughly 12 months. The decision makers were making dovish comments and boasting about the ECB’s extensive toolbox and their willingness to use the tools. Still, nothing happened.

After the meeting, Draghi, then others, played the same record of 'ECB ready to act' with even quantitative easing green lighted. In my mind, the obvious question should be if the ECB is ready to act and the numbers support further monetary action, why didn’t the ECB act in March? Even though ending the sterilisation would have been a short-term measure at best, it would still have been a strong signal that the ECB is willing to use the tools it has, and is serious about its mandate of targeting two-percent inflation and secondarily sound macroeconomic situation. In January, the ECB stated that either a further tightening in the money markets, or deterioration of the long-term inflation outlook would lead to further action. Today’s inflation statistics and the recent news of tightening liquidity certainly give enough reasons to act. Unfortunately, perhaps the Bundesbank is not that worried, as Andreas Dombret’s comments recently gave away.

Empty toolbox

So what is stopping the ECB from acting? Perhaps the ECB’s toolbox is emptier than it likes to state. A quick recap of possible monetary policy measures:

Ending the sterilisation of Securities Markets Programme: While this would be ‘instant QE’ and could be done with no additional preparations, and has been greenlighted by the Germans, in the March press conference Draghi stated reasons for refraining from such a move. Changing one’s mind now could be seen to decrease the credibility of the central bank.

Rate cut: There is not much room for a rate cut, but a symbolical cut is not out of the question. But, while the readiness for negative rates has been stated numerous times, it is improbable that such an untested and controversial measure would be implemented.

‘Classic’ LTRO: Banks could be offered new loans, but as long as the ECB is on the other hand conducting the asset quality review of the banks, it is probable that the pickup could be limited, and almost certain that it would not spur lending to households or corporations.

LTRO with mandatory lending/ABS collateral: This would be similar to Bank of England’s Funding for Lending Scheme, where the central bank offers banks cheap loans under the condition that the funds will be loaned to households and corporations. Devising such a measure correctly takes time, and the ECB (read: the Germans) would not like the increased risks to the ECB’s balance sheet that such a move would bring. A euro area-FLS would also require a more active and developed market for asset-backed securities and, due to the diversity of the euro area’s banking assets, devising such a system properly is no panacea.

‘Classic’ Quantitative Easing:The ECB would buy government bonds in the secondary markets, thus circumventing the ban on directly financing member countries. This would also increase the ECB’s balance sheet risks, and if done in proportion of the capital keys, it could drive yields to uncomfortably low levels for some member nations.

‘Freeform’ Quantitative Easing: This is a model recently proposed by several sell-side investment banks. The ECB would create funds and allocate them to the national central banks in proportion to their capital keys. The national central banks could do whatever they want with the funds. The upside is that Germans would not have to worry that ‘their funds’ are used to finance the Spanish deficit, and country-level considerations and targets could be used.

‘Mercantilistic’ Quantitative Easing: The ECB would buy foreign assets (probably government bonds from US, Japan, etc). This would amount to a currency intervention, as the ECB would create euros and buy foreign currency-denominated assets with the freshly-printed funds. This is what Switzerland’s central bank has been doing for some time now. Such an action would not be deemed to be financing the member nations, but unfortunately the world’s major nations have agreed not to conduct competitive devaluations. It is unlikely the ECB would violate that.

Pushing Spain over: Spain’s inflation fell to negative territory in March, and unemployment, budget deficit and non-performing loans are at record levels. One tool that the ECB does have in place is the much-praised Outright Monetary Transactions programme. By letting Spain go over the cliff and forcing the country to apply for the programme, the ECB would be able to proceed with Spanish bond purchases. Such a move is not probable, as it would lead to tensions and uncertainties, and filling the ECB’s balance sheet with Spanish bonds is hardly a popular idea in Germany.


b

 Spaniards might be welcoming the price of their tapas falling, but disinflation is bad news for the economy. Photo: venemama \ Thinkstock 


The need for a proper excuse

The ECB needs a proper excuse for not acting now. If it does not present a convincing excuse, its credibility after a continued pattern of promises and let-downs will be tarnished. The euro area’s banks’ reluctance to lend due to the asset quality review is the obvious candidate. The ECB could state that the current disinflation is temporary, and once the bank review is done, lending activity should pick up. If the ECB can provide a clear commitment to act in the style “whatever it takes, we will not tolerate another month of 0.5 percent inflation”, the end result from this week’s meeting might not be that bad. Other possible excuses include Russia’s annexation of Crimea, Chinese monetary tightness, the spillover-effects of Fed’s tapering and the emerging market volatility. All of these could be said to be temporary in effect.

Market impact

For the past year-and-a-half, the meetings of the ECB and the Federal Reserve Bank have marked the turning points for EURUSD. Expectations of a softer Fed have led to EURUSD rising before the Fed meetings, only to take a tumble afterwards. Similarly, expectations of a soft ECB have led to a falling EURUSD ahead of the ECB meetings, and afterwards the EURUSD has risen. The pattern has played quite well until now: the EURUSD fell following the Fed’s meeting, and the dovish statements from Europe have brought the currency pair lower. However, it looks like the the pair has this time started bottoming out early, as investors realised that the ECB will probably not act in April. Perhaps this week's euro area macro data still has the opportunity to increase market's expectations of some dovish action from the ECB: detailed purchasing manager indices, unemployment and producer prices are still to come before the meeting.

eurusd w meetings
Source: Saxo Trader

EURUSD w meetings longer
Source: Saxo Trader

The interest rate decision will be announced at 12.45 GMT Thursday and the press conference will begin at 13.30 GMT. The video feed can be watched here. The introductory statement will be posted here shortly after its presentation.

Charts from Thomson Reuters Datastream 

Draghi’s dashboard

Eurozone corporate lending rates 

QE / LTRO market reaction: a timeline 

Eurozone inflation and ECB repo rate

Eurozone money supply, loans

Previously on TradingFloor:

March 6 Post-meeting: All talk, no action from ECB disappoints markets

March 6 Pre-meeting: Draghi weighs up measures and monetary policy

March 5 Pre-meeting: What action can the ECB take?

Elsewhere:

Forbes March 30: Spain, The ECB And The Power Of Talk

Sober Look March 30: Why is the ECB hesitating on monetary easing?

Money Matters March 27: Partiam, partiamo or the ECB communication

The Wall Street Journal March 4: What Does the ECB’s ‘Sterilization’ Program Do?

Zero Hedge March 1: EZ Credit Creation Tumbles To New All Time Low

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