ECB Preview December 2013
Fundamentals Update as at 4 December 2013 by Lorenzo Beriozza
ECB set to ease again, but not already in December
Inflation will remain top of the agenda at this month’s ECB meeting and looking ahead it should lead to more stimulus from the ECB, but the meeting this Thursday 5 December will probably be too early for more action. The latest inflation print showed a small increase to0.9%, which in our view implies that the ECB will keep the powder dry for future lower inflation figures.
Nonetheless, ECB supremo Mario Draghi is likely to be very dovish and signal that the ECB is ready to act again. He will likely repeat his comment from last month, when he said “underlying price pressures in the euro area are expected to remain subdued over the medium term”. Inflation is expected to decline already in December, when it should reach 0.6%. Looking further ahead, inflation should bottom at 0.5% in March 2014, see Euro inflation still below ECB’s target, ECB will act again in Q1 14, 29 November, and ECB reaction to inflation over the next six months, 19 November. If inflation falls, the ECB is likely to act again to ensure that medium-term inflation expectations remain well anchored. The coming decrease in inflation is due to factors the ECB cannot do much about. Nevertheless, they will act to defend their inflation mandate. This happened last month, when the ECB cut the refi rate (the European interest rate) as lower commodity prices pushed inflation lower and it was also the case in 2008 and 2011, when the ECB hiked as higher commodity prices put upward pressure on prices. Inflation expectations have declined during the last month and although the fall is not alarming yet, lower inflation expectations are the main concern for the ECB. Hence we expect Draghi to be dovish and signal that he is ready to act again.
Credit contraction rings alarm bell
The latest data for monetary development should ring an alarm bell at the ECB, and it is likely that Draghi will mention weak credit growth as one of the downside risks to the growth outlook. Additionally, ECB’s monetary analysis should give it good reason to consider whether it is doing enough, and the latest data should certainly help to keep it on an easing bias. The decline in bank lending is partly driven by banks’ attempt to deleverage ahead of the ECB taking its snapshot of their balance sheets on 31 December for the AQR. Loan demand has shown signs of improvement recently, which offers some hope that bank lending will begin to improve early next year, when banks should be more willing to expand their balance sheets again. The ECB might wait for data that can give a first assessment of whether such a shift materialises before it embarks on further stimulus.
Some instruments should also work better after the snapshot has been taken.
Lower ECB inflation staff projections show need for stimulus
The need for more ECB stimulus should also be confirmed by the new staff projections. The ECB is expected to lower its inflation forecast to 1.0% from 1.3% in 2014, while the first release of the 2015 projection should come out far below the ECB’s 2% target at 1.4%. The outlook implies Draghi will be dovish and he will likely repeat his softened tone on the outlook for inflation from last month. The growth forecast is expected to be unchanged at – 0.4% in 2013 and 1.0% in 2014, while the ECB should project a pick-up in growth to around 1.5% in 2015. Last month Draghi hinted at an improved outlook due to fading headwinds as he said “the overall improvements in financial markets seen since last year appear to be gradually working their way through to the real economy, as should the progress made in fiscal consolidation”.
ECB likely to discuss a rate cut but refrain
The Governing Council is likely to discuss whether to cut rates again. The ECB will refrain from cutting further, but if the ECB were to cut again a small refinancing rate cut, which would lower the upper bound for short market rates by 10 or 15bp, seems most likely. This would make discussions about the impact of declining excess liquidity less relevant and help to keep money market rates down, although the impact is limited. The ECB could also choose to introduce negative deposit rates. This has both advantages and disadvantages.
- First of all, it would reduce the willingness to hold deposits at the ECB and would thus result in increased repayment of 3Y LTRO and thus a reduction in excess liquidity, which would push short market rates upwards.
- It should also cause an intensified search for positive yield, which among other things could help to reduce fragmentation as strong banks would be given more incentives to lend to weaker banks (excess reserves would become a “hot potato”).
- Negative interest rates would also be a cost for banks which are unlikely to pass negative rates on to their own depositors.
There seems to be widespread skepticism within the Governing Council about moving to negative rates and in particular Germany seems to be against this move. Joerg Asmussen said about negative deposit rates “I, personally, would be very, very cautious to use that one, but I would not exclude it” on 21 November. This view was also reflected by ECB Vice-President Vitor Constancio “Only in extreme situations, I think, could that measure be considered”. Constancio is considered less hawkish compared to Asmussen and is likely that enough on the Governing Council want to exclude such a move (at least for now).
The ECB has other options, but no magic bullet
The ECB has other instruments in the toolbox and Quantitative Easing (QE) is one of them. ECB chief economist Praet has said on 13 November that asset purchases is an option on the table, but although Constancio confirmed this on 19 November he also said that a debate on technical details of possible purchases has not taken place. If the Governing Council is unwilling to introduce full scale QE, one approach could be to halt the sterilisation of the Securities Markets Programme. This would free up around EUR184 billion in liquidity which is otherwise drained on a weekly basis. ECB may eventually embark on QE, but only if the deflation threat becomes much more pressing, and this is not likely to be the base case.
The ECB could also embark on a new LTRO (long-term refinancing operation). It is possible the ECB would make it even more attractive than the previous ones. It should be at least three years and in addition the ECB could attach additional sweeteners e.g. promise to keep the rate on this instrument at the current level or lower until maturity. Existing 3 year LTROs, repaid on a weekly basis, would probably to a large extent be rolled into such a new LTRO. Recently it was suggested that the ECB would make a Funding for Lending style LTRO, which would only be available to banks that agree to use the funding to lend to businesses. Such an instrument, which comes with conditionality, has to be more attractive than the current LTROs and it is not sure that the above-mentioned promise would be enough. Other alternatives include reducing the minimum reserve requirements. This could free up to EUR 100 billion in liquidity.
A new 3Y LTRO is the most likely first response to low inflation. However, it should not take place prior to the ECB’s snapshot of the banks balances for the AQR. Banks will be much more willing to use the facility after 31 December. As inflation is expected to bottom in March next year, announcement of further easing in Q1 seems likely.
ECB minutes may soon be published
Recently, a number of ECB Governing Council members have talked about publishing minutes of the Governing Council meetings and it is possible it will be announced at the meeting in December. This is likely to increase transparency about the decision making at the ECB, but there is also a risk that it will result in more political interference.
Market expectations
While most watchers expect further action to be taken to stimulate the weak European economy, few look for any action already this week. And, judging from where the markets are trading, it is unclear how much is priced in for this week’s meeting in terms of rate cuts or LTRO announcements. Hence, if the ECB delivers already now, it would push rates even lower, especially if the deposit rate is lowered. In our base case, Mario Draghi will do little else but sound dovish, which should probably be enough to keep rates in check for the time being. If the reserve requirements are lowered, this would ease the worry of a liquidity squeeze over New Year and thus lower the front-end rates a bit.
Source: Danske Bank
