ECB Meeting: Expected to decide on monetary policy easing. What can the markets expect?

Eurostat’s flash estimate today reported HICP inflation in November remained below consensus expectation for a 0.2% year-on-year increase in consumer prices. The inflation figure for November came in at 0.1 per cent on low oil price which has been exerting downward pressure on headline inflation for some time now. The energy component has shown a decline of 7.3% year-on-year. Core inflation dropped to 0.9% year-on-year from 1.1% in October. It is way below the ECB’s inflation target and highlights the deflationary pressure that the euro zone currently faces. It is true that consumption, especially in the services sector has picked up but unfortunately this increase did not reflect in services price inflation. Services prices increased only 1.1% year-on-year, lower than the 1.3% increase seen in October underlining ECB chief Mario Draghi’s low core inflation concerns.

Why does the euro need additional stimulus?

Today’s CPI data was the last to be released before the central bank’s governing council meets tomorrow to decide on monetary easing policy. With the core inflation continuing to alarm, it can be safely said that the dovish stance of the ECB will translate into ultra loose monetary policy tomorrow.

Too little inflation has hindered euro zone’s growth process for quite some time now. Inflation has remained below the central bank’s inflation target of 2% since 2013. The current inflation forecast of 1.7% for 2017 is pretty much unachievable. If the ECB does not inject additional measures now, it is possible that inflation in 2017 will remain as low as 1.3 per cent. In case inflation does not pick up as expected by 2017, euro zone will enter a situation similar to one faced by Japan now.

Going by the latest figures, it is quite possible that 2017 HICP inflation median projection will be revised downward to 1.6% below the ECB’s 2% inflation target. This alone should justify ECB’s decision to go in for aggressive easing. The trade-weighted exchange rate continues to remain extremely strong especially when pitted against a broader basket of currencies. This again adds additional pressure holding back inflation.

Watch: ECB Meeting Live Coverage by Valeria Bednarik, Yohay Elam and Dale Pinkert

In the absence of additional stimulus measures the challenges that the bloc currently faces will get deeply rooted. As the market gears up for the ECB meeting tomorrow, the focus continues to remain on the composition of the new easing tools that the ECB will likely adopt.

Draghi has hinted at further easing to raise inflation in the bloc. He might not want to go back on his commitment and run the risk of disappointing the market. He has repeated over and again that the QE programme was flexible enough to address downside risks. 

What are easing tools that the ECB will likely choose at its meeting tomorrow?

The ECB may opt to slash deposit rate by at least 10 to 15 basis points tomorrow. The central bank is considering the two-tier deposit rate system. This system will soften the impact of a deposit rate cut on banks, if the ECB chooses to slash rates further. Some analysts are also anticipating a refi rate cut to 0%, which if actually adopted by the central bank as an easing tool will be an additional boon.

It can also choose to expand and extend the QE programme. The ECB considering the low price situation may extend the QE beyond September 2016 and choose to continue it till March 2017. It may also expand QE scope by choosing to include regional bonds under its bond buying programme. Markets are also speculating an increase of the monthly asset purchase by about €10 billion. The markets are expecting another 300 billion in bond buying under ECB’s QE expansion programme. The Council will likely move the monthly asset purchases from the existing €60 billion to about €70 billion from January 2016. The expansion of the QE programme is expected to add extra €500 billion of asset purchases on top of the original €1.14 trillion. This will then amount to about 15 per cent of the bloc’s GDP.

The ECB is also possibly considering buying of rebundled loans. However, the central bank must be aware that buying bank loans will likely come with the risk of non-payment attached to it.

A discussion on split-level rate, to impose a higher charge on banks depending on the amount of cash they deposit with the ECB, is most likely being discussed by the council members. The split-level rate if implemented will increase the lower bound potential for short-end Euro rates.

If the ECB opts for Aggressive easing as is being expected by the markets, it will further weigh on the euro which has already fallen sharply over the last month.

Apart from initiating measures to boost price and stimulate growth, the ECB also must ensure that governments step up efforts to promote fiscal and structural policies. Only when relevant fiscal policies go hand in hand with expansionary monetary policy can the bloc attain the much needed boost to overcome disinflation and grow. Complete reliance on monetary policy will not help. If anything it will sow the seeds for the next financial crisis.