ECB Monetary Policy
Fundamentals Update as at 12 January 2014 by Lorenzo Beriozza
The European Central Bank (ECB) announced that it would leave its monetary policy rate unchanged at 0.25% and would take no further action this month, despite the looming threat of deflation in Europe. Inflation levels in the Eurozone dropped to 0.8% year on year in December, the lowest monthly rate since 2008. Inflation levels in 11 out of 18 states are under 1% year on year, well below the ECB’s target of “at or near 2%”. With inflation forecast to fall to as low as 0.6% in 2014, Mario Draghi will soon need to unleash some heavy weaponry if he is to win the war on deflation and protect Europe’s fragile economic recovery. So what weapons does the ECB have in its arsenal?
- The strengthening of the ECB’s forward guidance policy could help boost confidence. The ECB could follow in the footsteps of the US Federal Reserve and the Bank of England by linking any future rise in interest rates to a particular economic indicator, such as unemployment. Draghi reiterated his pledge to keep rates low for as long as it is necessary, but he crucially stopped short of linking a rates rise to an economic indicator. Greater clarity towards future monetary policy would be a positive signal to markets and may be helpful in the deflationary battle.
- The ECB could move rates into negative territory for the first time. This would mean charging banks for depositing money at the ECB, which could encourage greater lending and further push up inflation. Although the concept of negative interest rates has been trialled by countries such as Switzerland and Denmark, it has been on much smaller levels. Therefore, this relatively novel approach to battling deflation may have unforeseen consequences.
- The ECB could embark on a programme of quantitative easing (QE). Although the concept of buying bonds in the open market would be an effective defense against deflation, QE would be politically unpopular among countries such as Germany, which is concerned about the financial threat posed to the taxpayer.
Although the decision to hold fire and take no further action in the face of deflation will not come as a surprise to the market, it is hardly a decision that will be welcomed by investors. UK and European markets have so far reacted negatively in the wake of the ECB’s announcement, with the FTSE falling 0.2% shortly after the announcement. German bond yields slid 2 basis points to 0.197%.
The Eurozone recovery is expected to remain broadly on the right track in 2014. However, stronger and more decisive action from the ECB would help minimise the risks posed by deflation and accelerate Europe’s sluggish economic revival.
Source: JP Morgan Asset Management
