MacroScope

ECB rate cut expectations to be left deflated

By Mike Peacock
January 9, 2014

Euro zone inflation has dropped to just 0.8 percent and the core measure is lower still – at 0.7 percent it has fallen pretty consistently over the last year.

Nonetheless, the European Central Bank is likely to sit tight at its policy meeting today. The Bank of England’s rate setters are also meeting but facing a very different set of problems.

It’s probably too early for any dramatic moves but the ECB may well be pushed into easing policy if inflation refuses to pick up and/or the banks clam up ahead of this year’s health tests. Today, Mario Draghi is likely to reaffirm its readiness to act.

A shock fall in euro zone inflation prompted an interest rate cut to 0.25 percent in November followed by a chorus of denials that deflation was a threat. 

Draghi adhered to that last week but added that he and his colleagues had to make sure inflation didn’t get stuck in the “danger zone” below one percent. It’s been there for three months already. Furthermore, lending to euro zone companies shrank at the fastest pace on record in November.

With rates already close to zero, there will be no rush to cut them again, another gush of long-term cheap money for the banks is possible, particularly if the looming bank health tests cause them to tighten up further, but too many ECB policymakers are viscerally opposed to printing money for that to become an option unless deflation seriously took hold. 

Minutes of the Federal Reserve’s December meeting, at which it began slowing its pace of money printing, suggested the U.S. central bank will proceed with “tapering” cautiously, which could minimize ructions for its peers and the wider world.

Spain’s first bond auction of the year may indicate a further strengthening of demand for debt from the countries that have been at the sharp end of the euro debt crisis, particularly given fledgling signs of recovery in Italy and Spain. It will aim to sell up to five billion euros of 5- and 15-year bonds.

In market terms, one of the stories of the new year has been another lurch lower in euro zone peripheral bond yields.

The premiums Italian and Spanish bonds offer over benchmark German Bunds have dipped below 200 basis points for the first time since mid-2011 and in fact, the charts show the borrowing costs of Spain, Italy and Ireland – whose yields lurched lower after its first post-bailout bond issue was snapped up by investors – are down at the sort of levels seen before the global financial and euro debt crises struck.

Portugal, hoping to follow Ireland in exiting its bailout this year, is taking advantage and has mandated banks for a five-year syndicated bond tap as part of its drive to return fully to financing itself on the markets. It is expected to raise up to 2.5 billion euros.

France will also come to the market with up to 8.5 billion euros of long-term bonds. Despite record levels of debt, France enjoyed its lowest borrowing costs on record in 2013. Its 2014 issuance needs are basically the same as last year’s.

The question for the Bank of England is whether strong growth will push it to raise interest rates in 2014, much earlier than it had expected to. On that, the jury is out.

It’s far too early to shift tack yet although the economy is now growing strongly (albeit from a low base) and there are genuine questions about the housing market overheating. The rate of annual price growth is approaching double digits, is well above that mark in London, and mortgage lending appears to be surging, partly thanks to a government “help to buy” scheme.

The picture of a mixed Christmas in spending terms continues. Big winners have included John Lewis and Next. Tesco has just reported a heavy drop in underlying sales while Marks & Spencer’s clothing sales fell for the 10th consecutive quarter. Recruitment firm Hays says permanent job placements have outstripped temporary posts for the first time in two years.

Central African Republic president Michel Djotodia will face pressure to step aside at a regional summit in Chad on Thursday after losing the confidence of regional leaders. In South Sudan, rebels have rejected a government plan to unblock peace talks aimed at halting violence that has killed at least 1,000 people in the world’s youngest state.

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