Prepare for a razor-thin rate cut from the ECB in June. But what will it achieve?

May 9, 2014

RTR3OBCB.jpgA consensus appears to be slowly building for a carpaccio-slice interest rate cut from the European Central Bank next month.

What is also becoming increasingly evident is that it wouldn’t do much good.

Through economic research notes with titles like “ECB likely to do something next month” (JP Morgan), “ECB comfortable about acting next month” (Barclays), “ECB to act!… next month… (very probably)” (Rabobank), you get the depth of just how reluctant this central bank is to do anything, for all the talk of being ready to act.

ECB President Mario Draghi used his May press conference to signal that if his bank staff’s forecasts point to an even weaker inflation outlook , the Governing Council will duly oblige with further easing, likely a razor-thin 10 basis points lobbed off a rate that is already effectively at zero.

He is also worried about the euro, which is still rampant from his “whatever it takes” declaration in the depths of the sovereign debt crisis.

Getting it to weaken is proving the harder part.

J.P. Morgan’s Greg Fuzesi:

… it is now hard to see the ECB doing nothing at all at the next meeting. According to Draghi, the reason for waiting was that the new staff forecasts would become available at the June meeting. But, these projections are unlikely to prevent a policy change, given that the Governing Council would surely have had an early indication of what these will show at today’s meeting.

Our best guess is that the response will be relatively modest, aimed at trying to keep a firmer lid on the currency. We now think that a small 10 basis point cut of the main refinancing rate (to 0.15%) and of the deposit rate (to -0.1%) is likely.

Apparently the stigma of having one’s monetary policy echo past desperation from the Bank of Japan – which resorted to such razor-thin moves near zero while trying to get out of a punishing liquidity trap from which it has yet to emerge – is outweighed by the ECB’s duty to target inflation at just under 2 percent.

The fact the BoJ has still not been able to get inflation to 2 percent after the better part of a generation — scrapping its overnight call rate earlier this year altogether in favour of targeting the monetary base with gargantuan asset purchases — is conveniently overlooked by many.

The problem for the ECB is that inflation is nowhere near target and it won’t be any time soon. The latest Reuters poll of private forecasters has inflation averaging just 1.3 percent by the third quarter of next year.

Inflation is rising slowly from a trough of 0.5 percent in March, and may do some more in coming months. But 10 basis points of “stimulus”, when low rates aren’t enticing anyone to lend, won’t do a thing to get the economy revving at a speed that would start generating corporate pricing power or anything resembling wage inflation.

Unemployment, while edging down slightly in some countries, is still well over one-quarter of the workforce in the euro zone’s fourth largest economy, Spain. It is the same for Greece.

Economists at Barclays:

We think that in June the ECB will probably announce a small cut in the refi rate to 0.10%, accompanied by a cut in the deposit rate to -0.10%. However, we doubt that this will be sufficient to significantly weaken the euro. Moreover, given the risk to see binding credit constraints weighing on the recovery, we believe a targeted injection of liquidity would be appropriate.

EuroLena Komileva at G+ Economics:

It will be extremely difficult for the ECB not to deliver some action in June, and a 10 bps refi rate cut looks like the path of least resistance, to avoid the risk of inviting unwanted euro strength in the markets in the event of leaving rates unchanged.

However, since a small rate cut would be of little significance for the markets at this juncture; especially in view of the increased volatility of short-term Eonia rates compared to the ECB’s refi target, further unconventional liquidity will likely be needed to ensure easier financing conditions in the markets, to address the issue of weak real-economy credit and to generate more lasting downward pressure on the euro.

Economists at Credit Agricole:

Our central case is for the ECB to cut both its main refinancing rate (to 0.15%) and the rate on the Marginal Lending Facility (to 0.50% or below) in June while extending the fixed rate, full allotment regime into 2016, from mid-2015 currently. The ECB would only cut the deposit rate in parallel if the euro appreciates further above $1.40. There is no guarantee that even a negative deposit rate would materially impact the currency, but the ECB itself, including Bundesbank President Weidmann, said it would be the appropriate response to euro strength, at least in a first step. Those easing steps are generally described as modest, if not timid, and could indeed be ‘too little, too late’ to weaken the currency. However, there might be little else the ECB can do at the moment.

Having already been lectured by the International Monetary Fund, the Federal Reserve, and the Bank of Japan about the dangers of deflation, Draghi’s message was: enough.

We are independent, so people should be aware that if this might be seen as a threat to our independence it could cause long-term damage to our credibility.

Independent or not, it is clear it will take a lot more than 10 or 15 basis points and some more liquidity measures to change course, let alone get ahead of the exchange rate, which now appears to be driving ECB policy through its downward pressure on imported inflation.

That, along with its reluctance to act, may prove more threatening to its credibility.

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