Eurozone monetary policy outlook – 50bp and roadmap to QE
The ECB convenes on Thursday and is widely expected to announce a further interest rate reduction that will take the key refinancing rate to 1% from 1.5%. As part of the policy easing, the ECB is expected to announce it will extend the maturity over which it lends funds to the banking sector and that it may accept a wider range of collateral from the banks in exchange for short-term funds.
The chance of the ECB lowering rates by more than ½% is small, not because the economic situation doesn’t warrant it, but because it is not the ECB’s style and the ECB hasn’t indicated that it may consider a larger cut. The ECB also views the reduction in the main refinancing rate from current levels as more of a sentiment boosting measure, than one that will have an actual notable impact on the real economy. Thus, not sanctioning a larger cut will leave room for a further reduction at a later time.
There is a small possibility that the ECB lowers the refinancing rate by a ¼% for technical reasons, which could happen if the ECB announces a package of quantitative easing measures, but the likelihood of a less than a ½% rate cut is negligible.
What markets are keener on, is to gauge from the ECB statement and press conference if the ECB is coming closer to the point of following the BoE, SNB and the Fed in purchasing assets from the markets in order to increase the supply of money in the economy.
The ECB’s measure of money supply, which is part of the ECB’s two-pillar strategy of monitoring and controlling inflation and the supply of money, shows that M3 (broad money) growth has slowed sharply in the past year to an annual rate of less than 6%. Credit growth to the private sector also slowed to a rate of 4.2% y/y in February, or the slowest pace of growth in fourteen years. These rates will fall further in the coming months.
Meanwhile, economic growth is contracting at an increasing rate and unemployment is beginning to rise notably. GDP is expected to fall by approximately 3.5% this year, with growth in Germany the weakest due to the big decline in global trade. France is expected to outperform, but to still suffer at least 2% negative growth and Italy, the third largest of the Eurozone economies, to contract by the average for the Euro-area. The unemployment rate in the Eurozone is expected to rise to 10% this year and to increase above 11% in 2010.
As economic growth suffers its biggest contraction in decades and energy prices retrench, inflation is falling at a rate faster than anticipated either by the market, or the ECB. Annual inflation in the Eurozone slowed to 0.6% in March and is likely to decline further and possibly fall below zero in the near term. Inflation dynamics may change if oil prices rise significantly to say above $70 brl, but that is not for the near term as demand for energy is weak. As general demand in the economy declines and unemployment increases, inflation can be expected to remain subdued and prices may even start to fall.
With money supply growing at a notably slower pace, economic activity contracting at its fastest rate in a generation and inflation close to zero, the ECB can afford to stimulate the economy further along the lines of what the BoE, SNB and the Fed have done. The ECB has been fearful of inflation indexation in wage agreements, but unemployment in the Eurozone is rising at a fast enough pace for labour unions to have no negotiating power in forthcoming labour agreements. The rapid decline in inflation and a big drop in productivity growth, will also make it hard for workers to secure anything but a marginal wage increase over the next two years.
The ECB has little to worry about inflation at the moment. The Eurozone economy will be one of the weakest in the World this year, in part because of less fiscal and monetary stimulus by the authorities than elsewhere and in part due to a highly valued exchange rate, with the latter finding support in the ECB’s reticence to match other central banks’ policy efforts in full.
Judging by recent rhetoric, the ECB is warming up to the idea of quantitative easing, while maintaining that it may not be quite ready to start yet. Some members on the ECB Governing Council have been more open in their support of quantitative easing and others who had previously been apparent policy hawks, notably Germany’s Axel Weber, are also showing signs of succumbing to the idea of some form of money creation.
The ECB is not expected to announce the start of quantitative easing at its Thursday meeting, even if such steps cannot be ruled out, but it is probable that it will make some form of commitment to take quantitative action before long. The markets are priced to a dovish ECB, but the latter could surpass general expectations.