Time for shock and awe: Five questions for the ECB
This week’s European Central Bank meeting is shaping up as one of the most anticipated in years as the central bank gears up to boost a frail economy with a series of stimulus measures.
A global trade war threatens to push the powerhouse German economy into recession and headwinds from Brexit are becoming stronger. No wonder the ECB has all but promised fresh stimulus on Thursday, one of the last steps the bank’s chief Mario Draghi can take before stepping down on Oct. 31.
“This will probably be the most interesting meeting since March 2016 because we have this confluence of economic issues, political issues and a transition to a new president coming together,” said Pictet Wealth Management strategist Frederik Ducrozet.
He was referring to the 2016 meeting where the ECB slashed its depo rate to -0.40%, increased monthly asset purchases to 80 billion euros including corporate bonds, and launched a second round of cheap multi-year loans.
Fast forward to this week and here are five key questions for markets:
1. How low will rates go?
The ECB is leaning toward a package that includes a rate cut, a beefed-up pledge to keep rates low for longer and compensation for banks over the side-effects of negative rates.
At the very least, markets expect a 10 basis point cut in the deposit rate to -0.50% — the first cut since 2016.
Money market pricing ECBWATCH suggests some investors are betting on a bigger 20 bps cut; nearly a quarter of economists.
The ECB may could also use its forward guidance to flag another cut in coming months. Markets price in 35 bps worth of easing in total by end-2020.
2. Will the ECB restart QE?
Nearly 90% of economists expect the ECB to announce a return to quantitative easing (QE), starting with monthly asset purchases of 30 billion euros from October.
Analysts say this would likely be accompanied by tweaks to the ECB’s bond-buying rules given a scarcity of eligible debt. For instance, the ECB could increase the 33% limit on the share of a country’s bonds it can hold.
While not expected, any signs that the ECB could start buying equities or bank bonds would be a big surprise.
There’s also scope for disappointment with deeply negative bond yields suggesting investors are heavily positioned for stimulus. Some argue a new QE program worth at least 600 billion euros is needed to significantly lift inflation expectations.
Many ECB policymakers favor restarting asset purchases, but opposition from northern Europe complicates matters. Some officials such as Francois Villeroy de Galhau, Klaas Knot and Sabine Lautenschlaeger have played down the need for more QE, which ended in December.
3. How effective will the measures be?
After slashing rates to record lows and pumping 2.6 trillion euros of cheap cash into the economy since 2015, inflation remains below its near 2% target and growth lackluster. Inflation expectations suggest the ECB’s target won’t be met for years.
Little wonder many in the market question whether more stimulus would have the desired impact. More than 80% of economists were skeptical about the ECB’s ability to influence inflation.
Even if policymakers announced rate cuts, the relaunch of QE and reserve tiering simultaneously – matching or even exceeding expectations – Nomura analysts said it remained “questionable how significant an impact all of this will have on the economy.”
Still, more stimulus may boost growth through another route.
Pictet’s Ducrozet reckons that a very long, or open-ended QE program can encourage fiscal expansion: by keeping government yields low for longer, sovereign debt servicing costs will fall – creating the conditions for governments to spend.
4. What about the ECB’s inflation target?
In July, Draghi hinted at a reinterpretation of the inflation target, the cornerstone of the ECB policy framework.
Policymakers have targeted an inflation rate of ‘close to but below’ 2% for 16 years. Draghi, in his Sintra speech in June and again in July, talked about symmetry – the notion that inflation could rise above 2%, and then stay there.
That was a clear signal that the ECB’s unprecedented monetary easing bias could be left in place for longer to ensure higher rates of inflation.
At the post-meeting press conference, Draghi is likely to be pressed to spell out what symmetric means, or whether the ECB plans a formal review into its inflation target.
Peter Schaffrik, global macro strategist at RBC, reckons the ECB will go one step further by changing its forward guidance with an explicit reference to symmetry.
Not everyone is convinced, however, that Draghi even needs to talk about inflation targeting — this may be one decision best left to his successor.
5. Is the ECB likely to take steps to help banks?
Yes. One way to do this is to have a tiered deposit rate to ease the pain of deeply negative interest rates. The ECB has suggested it is considering this.
Tiering essentially means the ECB reduces the proportion of excess liquidity that is subject to the depo rate, currently at -0.40%. Excess liquidity — reserve bank holdings over and above the minimum requirements — is worth around 1.2 trillion euros or 10% of euro area GDP, according to Nomura.
This suggests that negative rates come at a significant cost to banks. But introducing a tiered depo rate is not without complications and there is no guarantee that tiered rates will alleviate pressure on lenders.
The second step the ECB might take, perhaps in combination with the first, is to boost the terms of a third round of cheap multi-year loans unveiled earlier this year.