Why Does the ECB Need to Ease?
1. Recession deeper than expected – Though the ECB slashed its 2009 GDP forecast to -2.7% at its March meeting, many analysts are expecting an even deeper contraction in 2009. Production has fallen off a cliff. Unemployment is rising, reaching double digits in Spain (14.8% in January) and 7.9% in Germany in February – higher than the UK’s 6.5% jobless rate. Domestic demand is faltering as the household saving rate (13.7% at the start of 2008) climbs further on job insecurity and portfolio losses.
2. Strong euro could nip export recovery in the bud – The euro has strengthened against its key trade partners, especially where quantitative easing precipitated a currency selloff – i.e., US, Switzerland, UK and Japan. A strong real effective exchange rate could make an export recovery much more difficult in the face of weak external demand. BNP Paribas estimated the rise in the euro’s REER this year has been equivalent to a 50bp rate hike.
3. Inflation threatens to dip into negative territory – The eurozone still posts higher inflation than the US, UK and Japan but has fallen below the ECB comfort zone of near 2%. ECB expects the eurozone may slip into technical deflation over the summer. Spain displayed the eurozone’s first negative inflation print: HICP declined for the first time ever since records began in 1961 to -0.1% y/y in March 2009.
4. Real interest rates are still high – Though consumer inflation is higher than its peers, its slowing pace and possible contraction may keep real interest rates restrictive. As of January 2009, real interest rates on household and corporate credit have blown out past 2007 highs. See chart 1.
5. The monetary base continues to contract – On an annual basis, M3 growth remains positive but has slowed relentlessly since mid-2008. On a monthly basis, real M3 growth has been negative since mid-2008. See chart 2. Nominal M3 growth turned negative on a monthly basis in January 2009 for the first time since September 2000.
How Will the ECB Ease?
1. Conventional measures: 25 or 50 basis point rate cut? Most analysts expect a 50bp cut in the main refi rate on April 2, though such a move would push the deposit rate down to 0%. As we explained before in “ECB Monetary Policy: Tight-fisted or Misunderstood?”, the deposit rate has taken over the refi rate as the leader of market interest rates – insofar as the ECB has any policy traction left. With EONIA tracking the deposit rate, a zero deposit rate may be undesirable to some ECB members, which could form the basis for ECB cutting the refi rate only 25bp on Apr 2 or narrowing the rate corridor so that the deposit rate would fall less than the refi rate. However, downside risks will most likely push the ECB to cut 50bp as expected.
2. Unconventional measures: Credit easing first, then quantitative easing? With the deposit rate likely to fall near or at zero at the ECB’s April 2 meeting, the ECB will have little or no ammo left on the conventional policy front. Like its peers (Fed, BoE, BoJ, SNB), the ECB may have to crank up to more aggressive forms of unconventional policy to continue monetary easing. The ECB had begun credit easing in 2008, offering unlimited financing at the refi rate with a wide variety of eligible collateral. This has helped ease money market rates more than most other developed world central banks, though this success is seen more in 12-month LIBOR (Chart 3) than 3-month LIBOR (Chart 4). Moreover, the measures to date have yet to allay credit tightness beyond the interbank market.
The form of ECB responses to the credit crisis had so far been tailored to the eurozone’s small private debt market and mostly bank-based financial system in the Eurozone. However, the form has limited the scale of response: ECB measures have yet to do more than merely offset the monetary contraction. The ECB’s credit easing may have to morph from its passive form (where banks’ participation in the liquidity facilities is voluntary and contingent upon bank demand for liquidity) to a more active form (where the ECB makes outright purchases of assets) in order to raise supply and demand for longer-term credit, not just plug up short-term liquidity shortages.
The ECB’s first forays into quantitative easing may start with corporate bond and commercial paper purchases before moving on to government bond purchases. The lack of a common European taxpayer and a common European government bond will require more creative logistics and political maneuvering for public debt purchases. For example, which country’s government bonds should the ECB purchase? Should the EU ‘bailout’ some members? The ECB can avoid answering the hard questions while it experiments with private sector asset purchases and extends term repos to longer maturities. The ECB may also piggyback on quantitative easing by the Fed to spark inflation fears that will raise commodity prices and remove some of the deflation threat in the eurozone.
Data Sources: ECB, British Bankers’ Association
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