Berenberg Macro Views
Economics
ECB: action possible, but confidence should prevail
● Another sharp fall in inflation in March has put the European
●
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●
●
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●
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Central Bank’s (ECB) inflation forecasts at risk and increased the
chance of further monetary stimulus. However, as the recovery has
strengthened and broadened this winter, we expect the ECB to
maintain its stance.
The risk is clear: Headline inflation fell to 0.5% in March, the lowest
since 2009. That presents a serious risk for both the ECB’s 1.0%
inflation forecast for 2014 and the recovery of the inflation rate
towards the 2% target by the end of 2016. The likelihood that
inflation expectations will follow actual inflation downwards rises the
longer that low inflation prevails. That could risk perpetuating the
target undershoot.
On the other hand, the recovery strengthened in March despite
emerging-market turbulences, the Crimean crisis and the strong euro.
Eurozone economic sentiment rose further above its long-run
average. Core and periphery economies are both expanding faster.
Low inflation is helping the recovery at the moment, with consumer
confidence rebounding particularly strongly and retail sales in
Germany heading for their strongest quarter since the post-Lehman
rebound. Outright deflation in the Eurozone is thus an extremely
remote tail risk.
The recovery is beginning to erode slack in the economy and thus
ease disinflationary pressures. In Germany, the unemployment rate is
roughly 1.5pcp below the non-accelerating inflation rate of
unemployment (NAIRU), even as the cyclical upswing is just
beginning. The current wave of strikes for higher pay highlights that
wages could rise faster soon.
Discussions in the Governing Council are likely to be heated
once again. Even the hawks among ECB policy makers last week
highlighted that many tools, from rate cuts to outright Federal
Reserve-style quantitative easing, will be on the table. ECB President
Mario Draghi has shown as recently as November last year that he can
get the Council to act if the data constellation warrants it.
On balance, however, we expect the ECB’s confidence in the
recovery to prevail and see only a one in three chance of more
action. If there is more action, a modest rate cut in the main rate
would be the most likely tool, with a negative deposit rate or an end to
SMP sterilisation also possible.
The ECB will probably keep some powder dry to respond to
potential negative external shocks emanating from the Crimean crisis,
more emerging-market turbulence or further strengthening of the
euro. Quantitative easing remains a weapon of last resort.
Instead, the ECB will continue its verbal intervention against
euro strength, showing off the ECB’s monetary policy arsenal and reaffirming the central bank’s readiness to act if necessary.
Key Macro Views reports
Understanding Germany
– a last golden decade
ahead
13 October 2010
Euro crisis: The role of
the ECB
29 July 2011
Saving the euro: The case
for an ECB yield cap
26 June 2012
Tough love: the true
nature of the euro crisis
20 August 2012
Mind the court: the top
event risk in Europe
31 May 2013
Euro crisis update: the
bare essentials
29 August 2013
Europe 2020: Reaping the
rewards of reform
26 November 2013
Euro Plus Monitor 2013:
from pain to gain
4 December 2013
Global Outlook 2014: the
sweet spot of the cycle
13 December 2013
Banking union: help for
tomorrow, not today
19 December 2013
Eurozone: Debunking the
deflation scare
13 January 2014
31 March 2014
Dr Christian Schulz
Senior Economist
+44 20 3207 7878
[email protected]
1
Berenberg Macro Views
Economics
Inflation drop reflects past, future is brighter
The sharp drop in Eurozone headline inflation to 0.5% yoy in March is Sharp fall in inflation increases
grabbing the headlines. At its lowest level since October 2009, it fuels chance of policy action
deflation fears. Although these are considerably overdone, in our view, very
low inflation makes the continued competitive rebalancing within the
Eurozone more difficult and risks leading to lower inflation expectations,
which could perpetuate the inflation target undershoot.
Very low inflation is an after-effect of the euro crisis. The long recession Inflation is a lagging indicator
has led to very high unemployment rates in many countries. This slack is reflecting the euro crisis aftermath
greatest in the crisis countries (see Chart 1). The tax increases and
government spending cuts imposed in the last few years have weighed on
domestic demand, further diminishing upward price pressures. This is why
the crisis countries feature at the bottom of the range of inflation rates in
the Eurozone, with Spain reporting -0.2% harmonised index of consumer
prices (HICP) inflation in March, for example.
But a large degree of slack is far from universal in the Eurozone. Large slack not universal in
Germany’s unemployment rate of 5.0% on the harmonised measure is 1 to Eurozone
1.5% below the NAIRU as calculated by the Organisation for Economic
Co-operation and Development (OECD, see Chart 1). The ongoing strikes
of its public sector workers and pilots, who are demanding 7-10% higher
wages, highlight the tight labour market in the Eurozone’s core. The
discrepancy between inflationary pressures between the core and the
periphery is desired as it facilitates the competitive rebalancing of the
currency union.
Recovery will lead to inflation
The overall inflation rate is likely to stabilise soon. The recovery is gaining rebound over time
pace and becoming more balanced (see Chart 2). The EU Commission’s
economic sentiment survey rose further above its long-run average of 100,
reaching 102.4 in March. We expect growth to slightly exceed the ECB’s
1.2% forecast for 2014. Economic slack will diminish faster and eventually
start normalising inflation, as it usually does. Once the clean-up of the
banking sector is completed with the ECB’s asset-quality review and stress
test this year, the credit cycle should also kick in and support more-normal
money growth.
Chart 1: Ample slack
Chart 2: But recovery heralds inflation rebound
2
120
5
110
4
100
3
90
2
1
0
-1
-2
2013
-3
2014
-4
80
2015
1
Econ Confidence
70
-5
-6
Germany
France
Euro17
Italy
Portugal
Spain
Difference between OECD-estimates of NAIRU and Berenberg
unemployment forecasts. Sources: OECD, Berenberg forecasts
60
2007
0
Inflation
-1
2008
2009
2010
2011
2012
2013
2014
EU Commission economic sentiment indicator (left-hand scale), HICP
inflation, yoy %, (right-hand scale). Source: Eurostat, EU Commission.
2
Berenberg Macro Views
Economics
What if? Long list of policy options
The sharp drop in inflation in March could trigger a heated debate about
additional easing action again. The list of tools is long. These are the key
ones, with a brief description of their pros and cons.
Rate cut: With the main rate at 0.25%, the scope for further rate cuts is Small rate cut would be least
limited. Another cut to 0.1% would be the least controversial, reducing the controversial
funding costs of those banks still borrowing large amounts from the ECB.
However, it is unlikely to be a game changer. The effect on the real
economy would be small, but the signal a rate cut would send should not be
underestimated. Furthermore, a potential weakening of the exchange rate
might boost export chances and import prices and, thus, inflation.
Probability: 33%.
End of SMP sterilisation: The ECB is currently sterilising the remaining Increasing excess liquidity by
stock of €176bn of Italian, Spanish, Greek, Portuguese and Irish sovereign ending sterilisation
bonds by inviting banks to deposit an equivalent amount with the ECB for
one week each week. This facility is remunerated at roughly the main
refinancing rate, i.e. 0.25%. Since the bonds have a much longer maturity
than the deposit facility, SMP currently acts like a mini version of the US
Federal Reserve’s former “Operation Twist” programme. By suspending
the sterilisation, the ECB would turn SMP into a “mini QE”, which could
exert downward pressure on short-term interbank rates. Banks would have
to deposit the funds at the ECB at the deposit rate, i.e. 0%. That might
tempt them to look for other places to deposit the money and stimulate
more interbank lending. The drawbacks are that: (1) banks might repay the
excess liquidity quickly; and (2) short-term interbank rates are already very
low so the impact would be small. Probability: 30%.
Negative deposit rate: Cutting the deposit rate to negative would penalise Incentive for more interbank
banks for holding excess liquidity. The desired effect is to spur banks to try lending with potential side-effects
to lend the funds to each other and thus lead to even lower interbank-rates.
The drawbacks are that: (1) banks may instead further reduce the amount
they borrow from the ECB, accelerating the decline of excess liquidity; (2)
banks may pass on the cost of keeping deposits at the ECB to clients and
thus increase borrowing costs; and (3) short-term interbank rates are
already very low, so the impact would be small. Probability: 20%, although
policymakers such as Austria’s Ewald Nowotny have mentioned it in recent
interventions.
Targeted long-term refinancing operation (LTRO): This would involve Bank of England style “funding
offering cheap long-term loans for banks with restricted collateral eligibility for lending”?
(like the Bank of England’s “funding for lending” scheme) – for instance
no sovereign bonds, or varying interest rates according to maturity. During
the December 2013 press conference, ECB President Draghi seemed to
suggest that future cheap loans to banks would be more targeted than the
three-year loans of 2011/2012. He criticised the banks for investing most of
the funds into government bonds, which meant little had reached the real
economy. He also vowed that the ECB would not subsidise banks’ capital
formation and, thus, profits. Targeted LTROs may not be very attractive
for banks, however, and therefore too small to constitute a significant
easing. Targeted LTROs could have non-linear effects across countries due
to different collateral availability. Probability: 10%.
Super-LTRO: The ECB could offer new, cheap, very long-term loans to Super-LTRO reloaded
banks as a successor to the expiring LTROs. The drawbacks are: (1) with
3
Berenberg Macro Views
Economics
banks currently repaying the existing loans, demand for new ones may be
low; and (2) the ECB itself sees a risk that super-LTROs could subsidise
bank profits without reaching the real economy. Probability: 10%.
Easing collateral requirements: Over the course of the euro crisis, the Collateral requirements already
ECB repeatedly allowed additional collateral for its cheap loans or eased very generous
requirements and reduced haircut. As concerns about the quality of some
of the collateral mounted, however, the easing stopped. Neutral moves like
easing requirements on certain types of asset-backed securities (ABS), such
as those backed by loans to SMEs, while tightening those on other assets,
are still possible. Probability: 10%.
Targeted asset purchases: Last summer ECB President Draghi hinted at Limited asset purchases = limited
the possibility of the ECB buying ABS to ease monetary conditions in the effect
future. In the absence of a liquid and transparent Eurozone ABS market,
the ECB and the European Investment Bank together launched the ABS
initiative. Asset purchases, however, remain a tool for the future. More
likely is a re-activation of covered bond purchases, of which the ECB
already bought €70bn in two waves during 2010-2012. The impact on the
real economy was small at the time, and is unlikely to be much greater this
time. Probability: 10%.
QE: This is the ultimate tool to influence interest rates and inflation QE more mainstream now, but
expectations when interest rates reach the zero bound. The ECB would still last resort
probably buy bonds of all member states, according to the share in GDP or
bonds outstanding. Long a taboo, the apparent success of QE in the US,
the UK and Japan has reduced the ECB Governing Council’s aversion to it,
as Bundesbank President Jens Weidmann’s intervention last week
highlighted. The German constitutional court’s rejection of outright
monetary transactions (OMT) has made QE a viable option as an
emergency intervention tool should bond markets become more turbulent.
The ECB will probably exhaust all other options in its tool kit before it
resorts to QE, which would still be highly criticised in many core Eurozone
countries. Probability: 10%
OMT: The ECB’s elegant safety net can only be activated for countries OMT faces extra hurdles
with bail-out packages, including a primary market purchase facility.
Currently no country has such a programme. Furthermore, the German
constitutional court’s objections raise doubts about whether the German
Bundestag might veto any rescue package that would create the preconditions for OMT. Probability: 0%.
Conclusion
We expect the ECB’s trust in the still nascent, but increasingly No action as trust in recovery
strengthening and broadening, recovery to prevail at the meeting. But the prevails
sharp drop in inflation to 0.5% in March has raised the likelihood of action
to 33% again, with a modest main rate cut to 0.1% the most likely step. In
November last year, a sharp drop in inflation triggered a surprise rate cut.
This time, however, the recovery looks much more solid, so that we see a
66% chance that the ECB will maintain its current policy.
4
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9