With All Eyes Again On Draghi, This Is What Remains In The ECB's Toolbox

As Eurostat surprisingly reported earlier today, Europe has once again descended into deflation, and not just due to sliding energy prices but also in the core inflation rate, which strips out the volatile items of energy, food, alcohol and tobacco, and which was also weak falling to 0.8% from 1%.

 

Still, as Reuters observes, "although consumer spending, virtually the only engine of growth, is holding up relatively well, an array of weak business sentiment surveys and poor PMI data indicate that the 19-member currency bloc is increasingly suffering from the emerging markets slowdown."

As a result, today's deflationary report, the worst since the start of Europe's QE, virtually assures another substantial round of policy easing from the European Central Bank on March 10.

Nordea economist Holger Sandte, cited by Reuters, said that "deflation would be a disaster for the euro area as the burden of high debt would increase. Therefore, the ECB will continue easing monetary policy significantly. But no matter what the ECB decides to do on 10 March, inflation is likely to hover around zero during the next few months before it picks up – if oil prices behave well."

It's not just analysts: Bank of France Governor Francois Villeroy de Galhau, an influential member of the ECB's Governing Council, warned over the weekend that the central bank would have to act if the low energy prices appeared to have long-term effects.

As Reuters adds, the worrisome inflation print comes just days after the G20 meeting of the world's top economies warned that leaders needed to looks beyond ultra-low interest rates and printing money to shake the global economy out of its torpor.

Still, the meeting failed to outline any bold steps and even called on central banks to maintain accommodating policies as weak Chinese growth weighs on all top economies and low commodity prices raise the specter of deflation.

This, until the surprising PBOC RRR cut, had pressured US equity futures into a lower open until a the traditional pre-market open ramp pushed futures into the green.

In any case, as we said last night when summarizing the post-G20 landscape, "the next big move in the market is now entirely in Mario Draghi's hands" after quoting Citi's Steven Englander:

The ECB is in focus. EZ is undershooting on growth and inflation, and ECB President Draghi has been impassioned on the need to provide more stimulus. If they lowball or grudgingly meet expectations, we could face another December 4 move because market participants will see it as the equivalent of a ‘last ease in the cycle announcement’, basically ECB throwing in the towel. If they move aggressively (and take measures beyond vanilla QE and 10bps on rates), they will catch market off guard and unwind the view that policymakers see themselves as powerless.

This has prompted speculation just what it is Draghi will announce in 10 days:

"The inflation data puts more pressure on them to do something. Unfortunately, the number of instruments for them is not increasing.” David Kohl, an economist at Julius Baer, said"

 

Can the ECB do something about it? Not much, or probably not," Kohl said, referring to the limited range of tools still left to the ECB after cutting rates into negative territory and venturing into unconventional policies.

 

The ECB is expected to cut its deposit rate by 10 basis points to -0.4 percent in March, charging banks even more to park their cash overnight, and investors also expect the bank to beef up it 1.5 trillion euro asset purchase program.

The ECB is already buying assets to the tune of 60 billion euros ($65.5 billion), hoping to boost lending, growth and prices but it has acknowledged that its inflation forecasts would have to be cut and its policies reviewed in March given that inflation will not return to target for several more years.

It will likely do more.

Here, according to SocGen, is what is next on the ECB's agenda:

  1. A 20bp cut in the deposit rate in March, to -0.5%, mainly in order to steepen the yield curve, likely with an announcement of an immediate or forthcoming introduction of a two-tier charge on excess reserves allowing the ECB to soften the impact on banks by exempting parts of excess reserves from the lowest rate. Our best “guesstimate” of the effective lower bound, based on the experience in smaller currency jurisdictions, is around -0.75%, but there is no technical limit per se;
  2. Extension of the TLTRO for one year, also in March, with four additional auctions until June 2017. Given that the recovery in investment has been slower than expected, there is an argument for maintaining the incentives for lending to the corporate sector, until a sustainable investment recovery takes shape. We would expect the same conditions to apply in terms of banks’ reporting obligations and with a fixed interest rate at the current MRO rate, with loans maturing in September 2019 or possibly a rolling three year ahead horizon. A specific reason for the ECB to prolong this programme is that counterparties that used this facility in the first two auctions paid a spread (later abolished) and will be able to repay these loans (€212.4bn) as of September 2016. With both pricing and regulatory factors increasingly weighing on the current TLTROs, we see strong reasons for the ECB to be even bolder, be it by lengthening maturities (forward guidance) or lowering the interest rate, possibly even into negative territory. In case consumer confidence starts faltering, including mortgage lending in the TLTROs may be an option; and
  3. Extension of the Asset Purchase Programme (APP) until December 2017. We currently don’t expect the (core) inflation outlook to improve sufficiently to end the APP in March 2017. Instead, we see a tapering to start around that point (reducing monthly purchases by €15bn each quarter), with purchases ending in December 2017, also in view of liquidity issues increasingly coming to the fore in 2017. This extension/tapering could be announced in H2 2016.

For the next meeting in March, we do not expect asset purchases to be accelerated, given the uncertainties over oil prices, the external outlook and liquidity. Recent concerns over banks’ profitability in an environment of low yields could also suggest some caution from the ECB to flatten the yield curve further, although, arguably, the ECB will also be concerned with pushing investors out of government bonds into less liquid and riskier assets. Importantly, any increase in the APP now would lead to questions over where the ECB could find assets in the future, if the APP is extended. A few clarifications could thus come as early as at the March meeting, depending also on the perceived financial market stress. Here we list a few options for the ECB in March, in order of likelihood:

  • Expanding into non-financial corporate bonds remains a possibility, but with limited volumes available, easing stress in the credit markets. Similarly, expanding collateral eligibility, or accepting non-performing loans in certain ABS formats as collateral, could support the securitization market.
  • Signalling the possible abolishment of the lower interest rate bound for APP. This limit is in place to stop the Eurosystem from making (automatic) losses on the APP. However, there is also a preference among some central banks for purchasing shorter maturities to avoid duration risk. A clearer agreement on profit and loss distribution in the Eurosystem could support an opening for allowing limited buying below the deposit rate, specifically enlarging the available German bond universe, although the legal hurdles still appear high;
    and
  • Signalling that changes in the issue share limit for non-CAC bonds and/or the country share limit remain possible. However, we think it will be difficult for the ECB to motivate such changes, in particular as regards the country share limit, due to risks of such a move being perceived as supporting fiscally weaker countries. Allowing for higher purchases of non-CAC bonds would be easier but could impact negatively on fragmentation.

Other more technical options that are possible in March include:

  • Details on purchases of regional government bonds;
  • Expansion of the list of public agencies, including more utilities (bordering on corporate bonds);
  • Following the Japanese example of adjusting the volumes for which negative rates are applied to mirror changes in cash holdings. This is an innovative way of removing the incentive to hoard cash (there is also some discussion on the merits of abolishing the €500 note, which would also make it harder to hold cash), and could thus make monetary policy more effective; and Sharpen communication on “forward guidance”, changing the current language of rates staying low for an “extended period”, or, better, providing future interest rate forecasts (à la the Fed’s dots or the Swedish central bank’s interest rate path).

Finally, here is a look at the ECB's full remaining toolkit:

With Draghi again signalling further easing, markets are closely scrutinising the tools at the ECB’s disposal. The remaining policy options relate to: 1) interest rates, 2) the asset purchase programme, and 3) liquidity operations, with each instrument depending on the nature of the challenges and the inflation outlook (see also Box 1 below on our assessment of the inflation outlook). Here is how we broadly see the ECB action panning out under different scenarios:

1) In a weaker (core) inflation outlook scenario:

  • Cut the deposit rate down to its new lower “effective” bound of around -0.75%;
  • Accelerate APP, with adjustments to the limits and assets likely if the programme extends well beyond March 2017.

2) In response to an unwarranted tightening in monetary conditions:

  • Same as above, but without adding new asset classes and with only temporary foreign exchange interventions.

3) In response to increased fragmentation:

  • Extend targeted liquidity for corporate lending;
  • Reduce MRO rate, possibly to negative, to increase take-up of TLTRO.

Other tools are possible in more extreme scenarios, such as the use of OMT and helicopter money, but would need clear support from governments due to the potential fiscal implications. In extreme adverse scenarios with euro break-up risks, ECB purchase support of
risky assets (bank bonds, ABS, equity) is also viewed as possible.