And some thought we were only kidding that NIRP is soon going to be Europe's new best friend. Also, if the former employer of Mario Draghi is now saying a rate cut is imminent, it means that the fiscal pathway to resolution is dead and that Friday's summit will be an even bigger disappointment than everyone now expects.
Just out from Goldman:
Change to our ECB call: We now expect a 25bp cut in the repo rate in July, but with the deposit facility rate left on hold
Tensions in the Euro area financial system are increasing again, on the back of rising government bonds yields in Spain and Italy. This is building pressure on the ECB to act. One dimension for policy action is interest rates. We foresee a 25bp cut in the main refinancing rate in July to 0.75%, but forecast an unchanged deposit rate, implying a narrowing of the interest rate corridor.
Such a rate cut would have little macroeconomic impact. While the funding costs of weaker banks that are dependent on the ECB’s operations would fall, the pass-through of lower rates to their household and corporate borrowers is likely to be very modest. And the funding costs of stronger banks with access to the interbank market are already well below 1%. Nonetheless, we expect the Governing Council to see a need to respond to renewed market tensions, so as to avoid seeming indifferent to developments or unable to respond to them. By demonstrating its willingness to play a part in sustaining the Euro, the ECB may hope to boost confidence in the current fragile environment.
Given the dysfunctional and segmented state of Europe’s financial markets at present, non-standard measures may be of greater significance in facing the Euro area’s current challenges (as ECB President Draghi emphasised at his June press conference). Last week’s decision by the ECB to broaden further its definition of eligible collateral demonstrates a willingness to resort to the non-standard toolbox. Should sovereign or bank funding conditions deteriorate further, other non-standard actions would likely follow.
Sliding back into recession
After showing surprising strength in the first quarter, the Euro area economy is sliding back into recession in mid-year, as reflected in the evolution of conjunctural indicators. The latest composite PMI points to a contraction of Euro area real GDP in the order of 0.2%-0.3% in the second quarter, in line with our own forecast (-0.3%). Our Current Activity Indicator (CAI) for June, which encompasses a broader range of monthly indicators, points to a slightly smaller contraction (of around 0.1%-0.2% on a quarterly basis). Moreover, given the current fragile market situation and policy-related uncertainties, risks around this central tendency are skewed heavily to the downside. We expect a further contraction of the Euro area economy in 2012H2, with the periphery suffering disproportionately.
Moreover, after peaking at 3% last year, Euro area inflation (2.4% in May) is now falling, although it remains above the ECB’s definition of price stability. Declining oil prices are contributing to the decline, but core components also show easing.
Broadly speaking, we see our baseline macroeconomic outlook (which has been somewhat more negative than both consensus and the ECB staff view) as intact. But the skew of risks to the downside is intensifying and, in particular, the financial market dynamics are deteriorating. It is these latter two dimensions, as well as the political environment, that have led us to revise our rate call.
One money, three monetary policies
European interbank financial markets are currently highly segmented, as intertwined sovereign and counterparty risks encourage home bias. The Eurosystem balance sheet is the nexus through which these segmented markets are connected, so as to preserve the unity of the single currency. But the terms on which the ECB offers its balance sheet as a vehicle for intermediation varies according to the soundness of the counterparty. And in the current environment of sovereign tensions, there is a high correlation between a counterparty’s financial soundness and its geographical location. Even with a single currency, the ECB can therefore be seen as running three distinct monetary policies for different groups of countries within the Euro area:
• In countries such as Spain and Italy, banks are heavily dependent on the ECB’s monetary policy facilities for their funding. Changing the repo rate will have a direct impact on their funding costs, both at the margin and on average (as the rate on the outstanding LTROs is indexed to the repo rate). Cutting the repo rate therefore appears to offer a vehicle for targeting monetary easing towards the peripheral countries most in need of it. But, in our view, peripheral banks are unlikely to pass the cut in their funding costs on to their borrowers (and thereby ease financing conditions in the real economy). In the second half of last year, when official and market rates fell significantly, the rates charged by Spanish and Italian banks to corporate borrowers remained stubbornly high (and/or rose). Dislocations in these markets persist and the traditional interest rate channel of monetary policy transmission remains impaired.
There are other channels through which a cut in the repo rate may offer stimulus. Reducing funding costs would improve the income position of banks and, over time, allow them to further rebuild capital. Other things equal, better capitalised banks would help support Spain and Italy. But the pace of such recapitalisation is unlikely to have much immediate impact. Moreover, should it weaken the exchange rate, a lower repo rate would also serve to ease financing conditions (although disproportionately so in Germany, rather than in the periphery).
But the main hope would be to build confidence and improve market sentiment via a cut in rates. Relying on such psychological channels of transmission when doubts exist about the underlying economic channels is a potentially risky strategy, but one we think the ECB will nevertheless adopt in the face of current pressure. Cutting the repo rate below 1% has never been a taboo at the ECB. We expect a 25bp cut to 0.75%, with a significant risk of a larger 50bp reduction. Should the cut be limited to 25bp in July, scope for a further 25bp later in the year would remain. (That said, our current point forecast for the repo rate at year-end is 0.75%.)
• In Germany, banks face much easier funding conditions. The market is awash with liquidity. Banks can access the market at rates well below the repo rate and the opportunity cost of funds in an environment of ample liquidity is represented by the rate on the ECB’s deposit facility (at which the stock of excess liquidity is reabsorbed). Market rates are therefore priced off the deposit facility (currently 0.25%), with the overnight rate (EONIA) at around 0.35%. And in Germany financing conditions are very easy: short and long rates are the lowest they have ever been, while the current Euro exchange rate is weak relative to the historical behaviour of the Deutsch Mark. With domestic demand in Germany currently showing resilience and the economy running close to full capacity (as reflected in the low level of unemployment), the case for further monetary easing there from the already very accommodative stance is also comparatively weak. All in all, this points to keeping the deposit facility rate on hold (and thereby limiting the impact of ECB actions on market rates such as EONIA and EURIBOR).
Again, other effects can be envisaged. Lowering the deposit facility rate would increase the opportunity cost of holding excess liquidity, thereby encouraging banks to seek higher-yielding assets or to make loans. But German banks are unlikely to purchase peripheral assets in the current environment: concerns about peripheral risk are the reason why markets are segmented in the first place. Rather, a lower deposit facility rate would drive yields down further in Northern Europe, where the help is least needed. Moreover, as in other jurisdictions, there are a number of technical reasons associated with market functioning to keep the deposit facility rate bounded away from zero. As in other central banks, these have held sway at the ECB in the past, even if the merits of the underlying arguments are mixed, at least in our view.
That said, the ECB has not ruled out cutting the deposit facility rate: it has characterised the decision as being organised around a weighing up of the potential macroeconomic benefits (in terms of easing credit conditions further) against the potential microeconomic costs (in terms of market functioning). On the basis of the above discussion, in our view that trade-off currently comes down in favour of leaving the deposit facility rate unchanged. But there is a risk of a cut to 10bp. We see a cut to zero as unlikely.
• Finally, in countries such as Greece the marginal cost of funding for the banks is determined by the rate on emergency liquidity assistance (ELA). This is not made public by the authorities. It can be varied in a discretionary manner. Recourse to ELA is, by its nature, symptomatic of a dysfunctional situation. In these countries, the scope for interest rate decisions to influence macroeconomic developments is even more limited.
More non-standard measures, but still largely in reactive mode
Given the segmentation of financial markets, the stance of monetary policy in the Euro area as a whole cannot easily be summarised by a single interest rate statistic. This is evident from the preceding discussion. Another implication, flagged by ECB President Draghi at his June press conference, is that quantity-focused non-standard measures may gain greater traction than conventional policy rate actions, especially in the countries where the traditional interest rate pass-through channel of monetary transmission is impaired or broken.
The ECB has demonstrated a clear commitment to maintaining the liquidity of the Euro area banking system. As we saw at the end of last week, where collateral shortages threaten to impair that liquidity, the ECB is willing to expand its definition of eligible collateral in a targeted but generous manner. And should peripheral governments face outright funding strikes—something that is getting closer—we would expect the ECB to acquiesce and/or be complicit in efforts to offer official support, while endeavouring to retain the pretence that market access is maintained.
This points in the direction of further non-standard operations, with longer tenor LTROs (i.e., offering financing indirectly through domestic banking systems) a likely channel, given the reluctance of the ECB to expand outright purchases via its securities markets programme (SMP). The ECB has also pressed for the EFSF / ESM to commence secondary market purchases of peripheral sovereign debt, something it has long seen as a mechanism to relieve itself of the immediate burden of such operations. This points to the ECB waiting to see what emerges from the EU summit and responding to market developments rather than changing to a more proactive stance.
Such action should not be seen as a solution to the current impasse. In the end—as we have learnt from experience with the 3-year LTRO operations earlier in the year—the ECB measures can only buy time: they do not solve the underlying fundamental problems. We expect the ECB to continue to contribute in this regard, but still in a manner that attempts to maintain pressure on the politicians and governments to make progress with institutional and governance reform.