The ECB may soon have to change its policy of keeping a 1.00% rate floor if JPM is correct.In a note just released by JPM's Greg Fuzesi, the JPM analysts says that "with the Euro area economy entering a potentially deep recession, we now think that the ECB will cut its main policy interest rate to just 0.5% by mid-2012. We expect the interest rate corridor to be narrowed to +/-25bp, so that the deposit facility rate will be 0.25%. We recognise that the ECB did not cut rates below 1% during the 2008/9 recession. It never fully explained why it did not, but we think that the two most likely reasons will be less important this time." And when the ECB does cut which it will have no choice considering Germany's stern reluctance to allow it to print outright, Hugh Hendry will make some serious cash. As a reminder, 'He’s made bets that he says will deliver a 40-to-1 return if the ECB cuts rates below 1% next year." Lastly, and as fully expected, the EURUSD is tumbling on the news.
First, by the time the policy rate had reached 1% in May 2009, the Euro area economy was already beginning to stabilise – the PMI troughed in Feburary and had increased almost ten points by June (first chart). This made it easier for the ECB to stay patiently on hold at 1%. This time the recession is only just starting, which we think will keep pressure on the ECB to make incremental policy changes. We also note that the already low level of interest rates and the small-ish benefit of additional rate cuts have not to stopped the ECB from cutting rates this month.
Second, the main policy rate can only be cut below 1%, if the ECB narrows its interest rate corridor below the current +/-75bp (or if it cuts the deposit facility rate to effectively zero). Back in 2009, the ECB saw positives in keeping a wider corridor of +/-75 bp as it implied a bigger gap between the effective overnight interest rate (at which good banks trade liquidity) and the main policy rate (at which troubled banks borrow from the central bank) (second chart). Hence, it saw a wider corridor as encouraging interbank activity and giving troubled banks an incentive to recapitalise. But, today, the EU has launched a more effective bank recapitalisation plan. In addition, the sovereign crisis has created a much more fundamental problem for banks, which limits the scope for using interest rate penalties in the same way.
As we expect the Euro area economy to be in recession until late 2012, we think that a 25bp cut in December will not be the last. Hence, we have now pencilled in additional easing of 25bp at the policy meetings in March and June 2012. As the deposit facility will reach 0.25% already in December, the additional cuts may not lower the effective overnight rate much. In our view, those moves would nevertheless send important policy signals.
What about other policy measures? Following Draghi’s comments about the huge challenges facing banks in terms of funding, collateral availability and capital-raising, additional support measures could be forthcoming. The ECB could, for example, commit to additional longer-term refinancing tenders, with maturities likely out to one year, and it could loosen its collateral requirements again.
What about QE? To many, the ECB is already doing this through its SMP, and believe it will be forced to continue by the lack of a political solution. There are similarities between this and QE, as both increase the size of the central bank’s balance sheet by purchasing government bonds. But, there are also differences in terms of motivation, context, sterilisation, and choice of bonds that are bought. It appears quite unlikely to us that the ECB will launch a more traditional asset purchase programme, which would buy government bonds from all countries and would be aimed explicitly at tackling downside risks to inflation. In contrast, the SMP is aims to reduce market dysfunctionality.