Euro zone inflation falls again; economists base ECB rate cut calls on deja vu

February 4, 2014

Euro zone inflation has dipped again and some forecasters are hedging their bets on the policy response by saying the European Central Bank could either cut rates this week or sometime in the next two months.

That lack of conviction, although not a recent phenomenon, is driven by memory of the ECB’s surprise cut in November after a similar drop in inflation and a nagging belief that things have not worsened enough in the interim to warrant another.

Only two of 76 analysts – Barclays and IFR Markets – in a Reuters poll conducted before news on Friday that January euro zone inflation fell to 0.7 percent said the ECB would trim its refinancing rate below 0.25 percent this week.

Now a few more, including Deutsche Bank and RBS say they will. While many economists say the decision is a close call, most lack conviction over whether it will do any good.

Money market traders aren’t convinced either, despite the fall in bond yields in recent days and the sell-off in emerging market assets.

Only three of 21 euro money market traders polled on Monday thought the ECB will pull the trigger on what could be the last bullet in the chamber.


Deutsche Bank economists, who had expected the refinancing rate to remain on hold until the second quarter of 2015 in the Reuters poll, wrote in a note:

We believe the ECB will respond to the further disappointing inflation news with a policy rate cut on 6 February. We expect the ECB to shift the policy rate corridor down by 5-10 basis points.

It is a question of timing. If not February, the easing will be in March, accompanying downwardly revised ECB staff inflation forecasts.

RBS economists, who were among the few to correctly predict the ECB’s rate cut in November, wrote:

The Governing Council needs more bad news on inflation like a hole in the head. (The) flash release does not force the Council’s hand, but on balance we think that a rate cut is the brave thing to do and the right thing to do and that is what we expect the Council to do.

We think that the outcome of this meeting is a close call, but on balance we think that a non-standard (i.e., less than 25 basis points) cut in the main refinancing rate is more likely that not.

We think that the Council will cut the refi rate to 0.1 percent. We do not expect a cut in the deposit rate, and a cut in the rate on the marginal lending is probable in this refi rate scenario but by no means certain.

Barclays was one of only two forecasters who forecast a rate cut this week in the Reuters poll, taken before the latest inflation data were released. Economists there wrote:

We expect the ECB to cut rates further to contain deflationary risks, either on 6 February, or in March at the latest.

We think the low inflation readings in the euro area, along with fears of a further decline into deflationary territory, will lead the ECB to cut the main refinancing rate next week by 15 basis points to 0.1 percent, and to cut the deposit rate by 10 basis points to -0.1 percent.

Scotiabank’s Frédéric Prêtet wrote:

Our main scenario indeed looks for additional rate cuts, both in the refi rate as well as a possible negative deposit rate. We expect this move to be taking place either at the March or April meetings.

In the latest Reuters Poll, Scotia forecast a rate cut only during the second quarter of 2014.

JP Morgan‘s Greg Fuzesi wrote:

It is a close call, but we think the ECB will stay on hold.

If the ECB does decide to act, would the response be meaningful? It could cut rates by another 10-15 basis points and it could raise the level of excess liquidity (e.g. by ending SMP sterilization). These steps would not be very impactful from a macroeconomic point of view. In contrast, the resistance to meaningful policies, such as asset purchases, still seems very high.

Bank of America-Merrill Lynch economists wrote:

Overall, the ECB likely will remain on hold with rates for this meeting and possibly next, in our opinion. However, any sharp or prolonged downward surprise to our inflation outlook would trigger immediate action; in addition the probability of a rate cut after the February or March inflation figure has gone up.

Overall, we believe the ECB is unlikely to react to temporary weakness in inflation, mainly driven by energy prices, unless it is surprised by 20bp or more on the downside or more persistent.

However, we believe the ECB faces a communication challenge in that it must convey a dovish outlook without anxiety to avoid exchange rate appreciation that would further add to a fragile outlook and, as a result, the inflation outlook. This raises the probability that the ECB will signal a rate cut, most likely in the two meetings following this one.

In the Reuters poll, BofA-ML had forecast that the ECB will leave rates on hold at least until the end of the second quarter of 2015, the end of the poll’s forecast horizon.

Commerzbank‘s Jörg Krämer wrote:

The ECB is likely to revise down its inflation projections in early March, suggesting a further easing of monetary policy in the medium term.

In the end, the ECB will further ease its monetary policy. We continue to think that rate cuts (refi rate: 0.1 percent, deposit rate: -0.1 percent) are somewhat more likely than other options such as conditional tenders. However, the bank will probably not yet act this coming Thursday, as the latest economic sentiment indicators have proved rather better than envisaged.

Wells Fargo economists and strategists wrote:

Although few analysts, ourselves included, expect the ECB to change its policy rate from its current setting of 0.25 percent next week, we are among the handful of analysts who look for another rate cut in the months ahead. We think that the potential threat of deflation—both the overall and core rates of CPI inflation are below one percent at present—will eventually force the ECB’s hand.

Daiwa‘s European economists, who say a rate cut by the end of the first quarter is likely, wrote:

While we think that the Governing Council is, on balance, just about more likely than not to leave policy unchanged next week, we also now think that it will have to follow through on its forward guidance and cut rates again in March. So, by the end of the present quarter the refi rate is likely to have been cut to just 10bps. And we also see a significant probability that the ECB’s deposit rate will be cut to negative territory, to -0.1 percent.

And IFR‘s global rates strategist, Divyang Shah, who had also called for a rate cut this week in the Reuters poll, wrote:

The ECB has two priorities at this week’s meeting.

Firstly, to take out additional insurance against disinflation as the EM crisis risks a disinflationary shock at a time when inflation is already low. This would involve a 10/15bps cut in the refi and deposit rates.

Second, is to enhance the liquidity environment and hopefully reduce money market volatility by shifting toward allowing the SMP to be left unsterilised.

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