The ECB cut the main refinancing rate to 0.25% from 0.5%, a new historical low; it also eased bank liquidity by extending the fixed rate full allotment for a further year (until July 2015) and maintained a uber-dovish forward guidance. The economic recovery in the Eurozone remains uneven and insufficient and the ECB is ready to do whatever it takes to fight the disinflationary environment. Overall, the meeting confirms a strong easing bias in Frankfurt, and in our view reinforces the ECB’s credibility as a deflation, as well as an inflation fighter.
At the november policy meeting, the ECB announced several key changes to its monetary policy. Let’s quickly look at what was announced and what we may expect in the next few months:
ECB cuts main refi rate, but keeps deposit rate at 0%.
The main refi rate was cut by 25 bps and is now 0.25%. The marginal lending rate was also cut by the same amount and now stands at 0.75%. The interest rate on the marginal deposit facility was already at 0% and was kept unchanged. Just like the rate cut last May, this cut is asymmetric.
Despite the disappointing inflation and monetary developments last week, the reaction of the EUR/USD exchange rate to the announcement shows clearly that traders were not expecting such a move (see chart below, Source: Bloomberg).
Bloomberg reports that out of 70 economists surveyed, only 3 were expecting a cut. However, the decision did not come as a surprise to us: last monday, in our weekly macro commentary (See The ECB should do more, now) we wrote:
“Confidence indicators continue to signal progress and institutional reform is under way. However, the two-speed recovery means that weaker countries are being left behind and are struggling to get debt dynamics under control, despite years of austerity. Deflation and deleveraging are still keeping Southern Europe depressed and will continue to do so unless either a reduction of real debts or an increase of nominal incomes is engineered. We expect the ECB to take immediate action in the form of reinforced guidance, and we see a further LTRO as likely. A surprise rate cut is a possibility.”
“The data suggests that while there seems to be an uptick in cyclical indicators, the structural headwinds to growth are still present. The above data (especially the ones on inflation) give the ECB enough firepower to fire a few bullets (maybe a new LTRO, maybe some reinforced guidance around negative rates). We would not exclude a surprise asymmetric rate cut with a further reduction of the interest rate corridor.”
We have already highlighted in many circumstances how the balance in the ECB governing council had shifted towards a more dovish stance, and we saw the data on inflation last week (a deceleration to 0.7% y/y from 1.1%) and on monetary developments the week before (M3 decelerating to 2.1% from 2.3%, private loans still contracting) as providing the Council with a strong case for further easing.
No super LTRO for now, but liquidity support for banks extended and forward guidance reinforced
The ECB did not announce a new LTRO, v-LTRO or s-LTRO, which some observers were expecting. In our view, it does not matter! Draghi announced instead that the ECB will keep its fixed rate full allotment procedure at least until July 2015 (that is a year longer than the previous guidance). This covers the whole period of the balance sheet assessment and asset quality review of banks, and significantly reduces the likelyhood of a liquidity crunch on peripheral banks. We believe the super LTRO is not needed and it would have limited impacts on bank deleveraging.
Forward guidance was maintained unaltered in its wording (including a downward bias for interest rates) but in our view was reinforced by the ECB’s actions. By extending the full allotment into 2015, the ECB has implicitly extended its policy horizon and possibly the meaning of “prolonged period of time”. Similarly, by cutting rates promptly it has shown its willingness to act and added to the credibility of the guidance.
Is the ECB running out of bullets?
With interest rates at all time lows and close to the zero bound, some may fear that the central bank has run out of ammunition and can’t fire more bullets. The official answer to the question is that the ECB could move to negative interest rates if needed. They probably can, but we see significant risk of capital flight attached to such a tool. Negative interest rates alone could have nasty side effects, as investors could simply withdraw their wealth from the financial system, and we see the asymmetric nature of the past 2 rate cuts as a clear sign that the ECB is aware of the side effects associated with charging savers interest for the privilege of holding euros. We expect the ECB only to announce negative rates in conjunction with other, powerful measures, including a quantitative easing program to ease the potential crunch from disgruntled European and foreign savers and absorb financial claims on its own balance sheet if market appetite for negative yielding assets is eroded.
Overall, the meeting confirms a strong easing bias in Frankfurt, and in our view reinforces the ECB’s credibility as a deflation, as well as an inflation fighter.
The next policy meeting is on December 5. You can view the full calendar of upcoming ECB policy meetings here, or you can browse the ECB Watch section of the website for our commentary of past ECB meetings.