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Nothing to suggest that the ECB is close to easing policy further
No major change in ECB thinking in past month.
• Fragile economy, low inflation and tighter liquidity still pose risks to recovery.
• ECB retains easing bias and says it’s still ready to act but few signs easing is close at hand.
• ECB hopes supportive talk will suffice. Action likely only if ‘accident’ occurs.
• FX response to Mr Draghi’s words suggests markets could seek to call ECB’s bluff.
As expected, today’s monthly policy meeting of the Governing Council of the European Central Bank left its key interest rates unchanged and didn’t hint at any substantive change in thinking that might suggest a policy shift is close at hand. ECB president Mario Draghi made it clear that an easing bias remains firmly in place and the general tone of his remarks was dovish. Yet there was nothing to suggest that the ECB is close to easing policy further, even if it wants markets to remain focussed on such a possibility
ECB Watching, Worrying And Waiting
Our judgement is that the ECB is now in ‘watchful waiting’ mode as a number of uncertainties remain to be resolved; will a still tentative recovery flourish or falter?; will inflation continue to drift to uncomfortably low levels?; could repayments by commercial banks of their Long Term Refinancing Operations (LTRO) funding lead to a firming in interbank rates that could damage the economy? The near term risks in regard to each of these issues are weighted towards outcomes in which the ECB could be forced to ease policy further. Mr Draghi captured such possibilities nicely today when he spoke of the ECB’s determination to avoid ‘an accident’ in relation to liquidity developments.
Yet with room for manoeuvre relatively limited—in spite of strong assertions today by Mr Draghi that it has ‘a vast array of instruments’ at its disposal—the ECB is only likely to act if one or more of these downside risks have crystallised. Our sense is that today’s ECB comments have not brought another easing materially closer, although there may be some risk that financial markets could call Mr Draghi’s bluff through a rise in the Euro on FX markets or a firming in interbank rate. However, the ECB’s assessment underlines how distant the day of an eventual policy tightening is at present.
Liquidity Concerns A Key Near Term Focus
The opening statement of Mr Draghi to today’s press conference struck very closely to a script that has been repeated for several months. While acknowledging some improvement in economic conditions and the persistence of subdued inflation, the ECB continues to provide its version of ‘forward guidance’ by promising its key interest rates ‘will remain at present or have levels for an extended period of time’. The only material amendment from last month began by repeating that the ECB would be attentive to any unwarranted tightening of liquidity conditions but added that they ‘are ready to consider all available instruments’ to counter such a development.
It is not entirely surprising that this technical issue was given extra prominence both in today’s statement and in Mr Draghi’s initial press conference comments. Previous ECB research suggested that when excess liquidity in the money market drifted down into a range with an upper boundary around €200bn, it might begin to put upward pressure on shorter dated money market rates. With excess liquidity estimated at around €210bn at present and commercial banks paying back some €3-5bn per week in LTRO borrowings, there was a risk that €200bn threshold would be seen before the ECB’s November policy meeting and in nervous markets a firmer trend in shorter dated money market rates might result that could threaten a rise in some lending rates facing firms and households.
Mr Draghi was keen to downplay this threat by highlighting that there was no stable relationship between the quantum of excess liquidity and shorter dated money market rates. He also emphasised the ECB’s determination to act against such an outcome if necessary and to use ‘a vast array of instruments’ at its disposal in that event. However, neither the introduction of another LTRO or even a cut in policy rates is entirely suited to address such circumstances. Furthermore, both responses could have unintended and possibly undesirable consequences. So, Mr Draghi remained long on determination but short on detail in today’s comments. As a result, we feel that the ECB would want to see clear evidence of firming money market rates before responding and would look to counter this initially through words rather than action.
Economic Upswing Still Sluggish, Concerns Emerging About Low Inflation
While the ECB’s assessment of economic conditions changed little in the past month, the press statement notes that ‘industrial production data point to somewhat weaker growth of the beginning of the third quarter’, a development that is consistent with the repeated view that ‘output is expected to recover at a slow pace’ and that the risks to this outlook ‘continue to be to the downside’. If the ECB seems more comfortable that Euro area economic activity has stopped contracting and may be starting to improve, it remains of the view that the emerging upswing is ‘fragile and uneven’. In these circumstances, Mr Draghi was keen to emphasise that an easing bias remains in place and also noted that a rate cut was again discussed at today’s meeting.
With a consensus building that the Euro area economy is edging forwards rather than tumbling backwards, the focus of press questions turned towards the problem of uncomfortably low inflation rather than lacklustre growth. Time and again, Mr Draghi repeated that the current low inflation rate (down to 1.1% in February, the lowest reading since February2010) was broadly as expected and that in the medium term inflation was likely to be consistent with the ECB’s target of an outturn below but close to 2%.
However, the recent rise in the exchange rate of the Euro threatens to add to disinflationary forces and also to weigh on recovery prospects. As a result, Mr Draghi said that while the exchange rate was not a policy target, it was important for growth and price stability and consequently, the ECB was attentive to such developments. As with the potential risk posed by firmer liquidity conditions, the threat posed by a rising Euro on FX markets is not easily addressed.
Our sense is that the ECB is aware of various sorts of risk posed by uncomfortably low inflation in the current environment. Although subdued prices help household purchasing power, low nominal growth also weighs heavily on the sustainability of both Public and private sector debt.
Make Promises You Hope Not To Have To Keep
With growth fragile, a non-negligible risk that inflation may run below the ECB’s target and some possibility of an unhelpful tightening in liquidity conditions, it is not difficult to see why Mr Draghi would emphasise that the ECB continues to have an easing bias. What is less easy to see are the precise trigger points that would force the ECB’s hand and, more disturbingly, how certain it is that a further easing would prove successful.
For all those reasons, Mr Draghi and his colleagues will be crossing their fingers that an economic or liquidity ‘accident’ can be avoided in coming months and that soothing ECB words will prove sufficient to see the Eurozone economy move onto a healthier footing. Unfortunately, as the rise in the exchange rate of the Euro in response to Mr Draghi’s comments today demonstrates, it is unclear that the ECB’s ‘verbal easing’ will prove sufficient against a still troubling array of risks to the recovery.