The ECB disappointed markets today, but set the stage for a possible “big bang” move next month: it cut the refi by only 25bp, as we expected, lowered the depo to 0.25%, did not announce a lengthening of the maturity for liquidity operations. However, Trichet stated very definitely that next month the ECB will decide if and how to implement further non-standard measures. I now expect a big-bang move at the May meeting, with another (final) 25bp cut in the refi rate, a lengthening of liquidity operations to twelve months, and the launch of outright purchases of private sector assets, likely including financials and corporate bonds and commercial paper, but not sovereign bonds. This would help unburden the banking sector, lessening the risk of a serious credit crunch and easing financing conditions for corporates. This could have a major market impact, lowering yields significantly and allaying concerns of a very prolonged slump in eurozone activity.
The ECB cut the Refi rate by a meagre 25bp today, in line with our outof- consensus call and disappointing market expectations of a 50bp cut. The decision was taken by consensus, with some Governing Council members apparently arguing for a larger (50bp) cut. Importantly, the ECB lowered the deposit rate by 25bp to 0.25%. Trichet clearly indicated that the deposit rate has most likely reached its floor, while the refi rate could be lowered further in a “measured” way. Asked why the Governing Council had not decided for a larger refi cut today, he elaborated that the widening of the corridor “has served us well” and they wanted to maintain it this time, but immediately added that this might be changed in the future.
We reiterate our call for another 25bp cut on the refi at the May meeting; the deposit rate will be left unchanged, narrowing the corridor. We also continue to believe that the 1.0% will prove to be the floor for the refi, unless the ECB becomes seriously concerned about deflation risks—as my colleague Aurelio Maccario has noted in his flash comment earlier.
DECLINING OFFICIAL AND MARKET RATES
The ECB is therefore pushing market rates close to zero via an extremely low deposit rate, while keeping the main policy rate well in positive territory. In my view, this strategy is guided by the ECB’s desire to be well positioned for a timely withdrawal of stimulus once the economy recovers. The ECB could then begin to push market rates up via the depo rate, without an early hike in the refi rate that could attract headlines and unwanted political pressure. Moreover, keeping the refi rate in positive territory can help send a signal that the bank remains vigilant against possible inflation risks down the line. I would favour a more transparent strategy, lowering the refi further while signalling that the ECB will hike as soon as necessary even in the face of pressure from peers and politicians—as it did in 2005—but I do understand the concern.
The ECB also disappointed market expectations (and ours) that it would announce today a lengthening of the maturity of its liquidity operations to twelve months from six. This would have been a natural further step in line with the ECB’s strategy of working through the banking system rather than by-passing it. However, this measure would fall short of addressing the key problem, which is the banking system’s need for medium-term funding. It is perhaps for this reason that the ECB decided not to take this step in isolation today. Instead…
…surprisingly clear and explicit was Mr. Trichet’s indication that at the next meeting the ECB will announce whether additional non-standard measures are necessary, and which ones will be taken.
We therefore now expect that at the May meeting the ECB will announce the launch of outright asset purchases. These will likely include financial and corporate bonds, and commercial papers, but probably not sovereign bonds—as we argued in our piece on Monday (“QE a’ la ECB”). Today’s conference bolsters our conviction in this call:
-
Trichet today acknowledged that tighter credit supply might be playing a role now, above and beyond the decline in credit demand. He stressed that the ECB would adopt further non-standard measures which could optimally ensure the flow of financing to the economy. This in my view will now require both helping the banking system further, buying financials bonds and lengthening liquidity operations, and by-passing it with direct purchases of corporate bonds and commercial paper. I realize the market for corporate bonds and CP is relatively smaller in Europe, but still believe that such direct purchases would be helpful in lowering financing costs and averting a credit crunch.
-
Trichet noted that in launching further non-standard operations, it would be essential to preserve the ECB’s role as an anchor of stability and credibility. To me this suggests that the ECB is likely to steer away from direct purchases of sovereign bonds, which could be interpreted as a monetization of fiscal deficits, as well as potentially distorting risk spreads.
The ECB has been reluctant so far to embark in direct asset purchases, probably because of the same desire to be able to tighten policy quickly enough once the time comes. Massive injections of liquidity via repos can be reversed easily and automatically once the repo comes to maturity. If the ECB buys assets, instead, it will face the more complicated issue of deciding when to sell them back onto the market.
The dire growth outlook, however, clearly calls for further action: with the eurozone now forecast to experience an even deeper recession than the US, and the risk of a credit crunch rising, it becomes much harder for the ECB to remain the only major central bank not to implement “orthodox” Quantitative Easing, that is outright asset purchases.
A DISMAL GROWTH OUTLOOK
Moreover, while the ECB continues to minimise the risk of deflation, it knows very well that a prolonged recession would put dangerous downward pressure on core inflation—while negating a rebound in commodity prices. Trichet admitted today that a decline in core inflation is starting to play an important role side by side with the well-known base effects on energy prices. He said the decline in core inflation would be temporary, but he knows very well that that hinges on a timely recovery of the economy. Inflation expectations remain well-anchored, but this cannot be taken for granted while inflation plunges in negative territory this summer.
NEGATIVE INFLATION IS LIKELY IN THE SUMMER
