ECB Preview: Mostly Thunder, Little Rain
The ECB meets tomorrow. There is much consternation among many observers over the ECB’s reluctance to recognize what they see as a potent deflationary threat. With the US economy gaining momentum and GDP per capita set to surpass its post-crisis peak here in 2014, it is Europe that is feared to be the next Japan. The secular stagnation hypothesis, brought back into the fore by Summers, seems to be more applicable to Europe than the US.
Yesterday, the preliminary estimate of euro area consumer prices was released for December. It stood at 0.8%, which is half the pace seen as recently as July, and the lowest since Nov 2009. The ECB’s target is close to but lower than 2% over the medium term.
In addition, other measures of the financial condition in the euro area are worrisome. Money supply (M3) growth continues to slow and trended lower throughout 2013. Lending to business and households has been contracting consistently since mid-2012. Lending to households appears to be stabilizing, but the lending to non-financial businesses is contracting at apparently an accelerating rate. There is also concern that the excess liquidity in the euro zone is falling primarily as banks repay their LTRO borrowings.
On a descriptive level, we take no exception with this narrative. To many, this narrative means the ECB action is urgent. A Taylor-like rule for the ECB suggests (San Fran Fed letter) suggests the ECB’s refi rate should be at 16 bp rather than the current 25. There are still calls for a negative deposit rate and/or a large scale bond buying operation (e.g. QE).
It is true that ECB President Draghi has surprised the market a few times on the dovish side. However, we suspect that many observers are thinking more of what they would do, if it were their decision, as opposed how the ECB is thinking about their challenge.
The ECB officials appreciate that the poor optics are part of what is likely to be an extended adjustment phase. The decline in euro area inflation, for example, is not totally undesired. The disinflationary, or even deflationary forces are in good measure, a reflection of what some economists refer to as internal devaluation. This really means that in order to regain competitiveness in lieu of a devaluation of one’s currency, which is the traditional path of the southern Europe, but blocked by monetary union, domestic prices have to rise slower than its main trading partners, but especially Germany.
Because of low German inflation, to regain competitiveness, even lower inflation in the EMU is needed. Some countries, such as Spain, can flirt with deflation, even as its economy appears to be improving, albeit slowly. Other countries, like Italy, are experiencing disinflation, though with an economy that still is struggling to gain traction. France appears to be closer to Italy in this context than Spain. French inflation is below Germany (0.8% vs 1.4%) and the economy has not convincingly emerged from the contraction phase.
ECB officials have mostly played down the risk of outright general deflation. The key here is Germany. At 1.4% headline CPI and a strengthening economy, deflation indeed does not appear likely. If German CPI falls below 1.0%, this might change the decision making dynamics.
Of the different headwinds that the euro area faces, the level of the refi rate does not seem to be among the most salient. The precision suggested by the Taylor Rule is misleading. That using the San Fran Fed’s assumptions would imply a 9 bp lower refi rate is really inconsequential. The ECB does not embrace the idea that monetary policy should be used to manage the economy. A 10 bp cut in the refi rate that some observers have called for is unlikely to be any more effective in addressing the purported deflation threat of the slowdown in lending than the 25 bp cut delivered in Q4 13.
Like the softness in the inflation metric, the decline in excess liquidity and the contraction in lending is likely not wholly undesired either. Paying back the LTRO borrowings is a sign that the banks don’t need the money. Italian and French banks appear to be lagging in the repayment, though they are expected to play catch-up in the coming months.
In the US, household de-leveraging was a major headwind to the economy. That seems to be over or nearly so. In Europe, banks were more leveraged than in the US and did not get the wholesale recapitalization from the government, the banks continue to de-leverage, forced, at least in part, by new capital requirements.
The ECB does want to help smooth this adjustment phase. A lower refi rate is unlikely to be very effective, especially as the repo rate trades closer to the zero deposit rate than the refi rate itself. While the ECB says it is technically prepared for a negative deposit rate, we see officials reluctant to adopt this nearly unprecedented measure that could hurt the very banks it is trying to help, as well as be disruptive for other economic stakeholders.
Outright sovereign bond purchases also seem unlikely, especially as Spanish and Italian bond yields are near multi-year lows. Trichet’s SMP program was highly controversial. In fact, by triggering the resignation of Weber (and Stark) the SMP program paved the way for Draghi’s ascendancy.
Some observers also want the ECB to lean against the euro’s rise. However, the tightening impulse coming from the currency is minor. On a trade-weighted basis, for example, the euro is about 1% above its 100-day moving average and less than 2% above its 200-day moving average. Before monetary union, Europe was mostly small and open economies. Under EMU, the euro area is larger but less open (reflecting the role of internal trade). Draghi has often said that the ECB monitors the euro and the foreign exchange rate is an input into monetary policy, but it does not target the euro’s exchange value.
Instead, if the ECB is going to innovate again, it may be in the direction of the Italian proposal of tying new funding to new lending. There has also been some suggestion of finding ways, perhaps through the collateral rules, to help facilitate securitization. This is seen as a possible inducement to greater lending to small and medium sized businesses. The ECB does not appear ready for such a step yet. Therefore, the most that can be reasonably expected from tomorrow’s ECB meeting is dovish comments from Draghi, suggesting that there are plenty of options available if needed.