With survey data pointing to a marked slowdown in the eurozone manufacturing sector, Exhibit 1; forward inflation expectations at 1.4% significantly lower than at December’s meeting; and a cut in the ECB’s projections for economic growth from 1.7% to 1.4% for 2016, anything other than a forceful response would have been received very poorly by markets. This would in our view also have been tantamount to a policy error. But unlike December, this time markets got what they wished for – an increase in the size and composition of eurozone QE.
We believe the ECB has in effect 3 policy options – broader and larger QE programs, more negative interest rates and finally pressuring governments to implement structural reforms and/or implement some form of fiscal stimulus. It is easy to see the last of these is hardly a policy option. Despite President Draghi’s pointed (and correct) remarks on fiscal stimulus and structural reform, the ECB is powerless to change eurozone governments’ policy except during a period of financial distress. Any emphasis on this latter option would therefore have been a bitter disappointment for markets. Ironically, there is much to say in support of Draghi’s views on the necessity of structural reform and fiscal easing, in order to close the growth gap between the eurozone and US for example. The problem is that markets equally correctly have absolutely no confidence anything is going to happen in that respect, absent another real economic crisis.
Between the remaining two options, QE has clearly been effective in raising ‘confidence’ in the sense of reducing risk premia (i.e. raising asset prices) whether in the US, Japan or Europe. Some improvement in economic momentum often follows. For that reason it was highly encouraging for investors to see an increase in both the size and composition of the ECB’s QE program; in our view over-emphasising negative interest rates (NIRP) would also have been a mistake.
Negative interest rate policy is still very experimental and investors have valid concerns over how it will help. These arguments are not complicated – if banks cannot pass on negative rates, they will then suffer margin compression and become more reluctant to lend. In this regard, it is interesting to note that ECB’s new bank refinancing program also announced today will have a rate as low as the deposit rate of -0.4%. If negative rates are not passed on, consumption and investment are hardly likely to be affected if negative rates do not reach the economy. This policy could then be seen as a barely covert attempt to manage exchange rates.
However, if negative rates are passed on to consumers, this raises the financial stability risk of a withdrawal from bank deposits, which may start slowly but could quickly accelerate – something hardly likely to incentivise bank lending. We continue to believe central banks would be best advised to tread carefully with any NIRP policy until the cost/benefit calculation is a little more obvious. Draghi’s comment that the emphasis will now shift away from interest rates towards other non-conventional measures is encouraging in this regard.
With the eurozone economy clearly stumbling again according to recent survey data the ECB had every reason to act now and we believe they have acted appropriately in magnitude and direction. Eurozone inflation is well below target and unemployment is still above 10% in the region as a whole. In terms of expectations, this is exactly where the US found itself in 2010 (unemployment 10%, CPI 1.2%) which may be instructive on the likely duration of ZIRP/QE in Europe. If US experience is a guide, the first increase in eurozone rates would be expected in 2021 – the same date as the expiry of the new bank refinancing facilities announced today.
In terms of the global picture, a more aggressive ECB raises expectations for US interest rate increases and therefore the monetary policy divergence between the US and eurozone is once again magnified. In these circumstances, which are in addition to the recent divergence in the economic surprise indices, Exhibit 2, the euro is likely to remain under pressure, despite the recovery during the press conference.
1. The ECB has exceeded market expectations by implementing all projected policy changes (more NIRP, more QE, buying non-bank corporate debt)
2. Aggressive action by the ECB re-imposes the policy divergence between the Fed and ECB – EUR likely to remain under pressure.
3. Based on US experience, NIRP/ZIRP likely in eurozone out to 2020.
4. Draghi’s comments highlighted the link between the new TLTRO and upcoming bank bond refinancing – credit stress within the financial system has been noted.