Think The ECB's Ex-Goldman Head Will Cut Rates Tomorrow? Not So Fast, Says Goldman

Anyone anticipating more easing out of the ECB's Mario Draghi first thing tomorrow may be in for disappointment, according to Goldman (which certainly should know how its alumni think), which says that "We expect the ECB to leave policy rates unchanged at its monthly policy meeting on Thursday, and also expect no further announcement of non-standard measures at this point. Before taking further measures, the ECB will likely want to have more clarity on how the macro picture is evolving and how successful the measures taken in December have been in stabilising the situation. That said, the press conference may provide further indication of where the threshold for additional ECB action lies." It is unclear how the EURUsd will react to any such interim halt in currency devaluation, but it is likely that the record number of shorts in the currency will hardly be overjoyed.

Full note from Goldman's Dirk Schumacher:

ECB preview: No rate change or further non-standard measures, for now

We expect this week’s monetary policy meeting to be a rather boring one, at least compared with the recent standard set by the ECB. Rates will likely be left on hold and we expect no further non-standard measures to be announced. The Governing Council, with some justification, probably views past steps taken as significant enough to merit a pause that will allow a further assessment of how effective these measures have been in easing tensions in the financial system.

Moreover, the more recent data out of the Euro-zone have been on average somewhat better than expected by the market consensus, although we think they are still consistent with a small contraction in economic activity. Finally, the depreciation of the Euro, although it is unclear at this point how long-lasting it will prove, will be interpreted by the Governing Council as providing an additional stimulus to the economy. In short, there seems to be little need for the Governing Council to take any immediate further action.

We discuss in more detail below what we believe would make the ECB spring into action again. One important aspect to keep in mind in all this, however, is that the ECB sees itself as engaged in a strategic game with Euro area governments. As ECB president Draghi made clear in a recent speech, a sound fiscal compact is a necessary condition for the ECB to be able to play its part in reducing the risk of any country running into an acute funding crisis. Thus, in addition to the usual considerations about the macro environment, the ECB will also be watching closely progress made by EU governments in the run-up to the next summit on January 30 (see last Friday’s European Weekly Analyst 12/01 for more on this).

More monetary stimulus wanted, but we don’t think it will come through further rate cuts

The ECB’s growth expectations, as set out in the December staff forecast, would in themselves not warrant any new ECB action, as the forecast still sees the Euro area growing moderately next year (+0.3%; GS: -0.8%) and then returning to around trend in 2013 (+1.3%; GS: +0.7%). But the Governing Council has highlighted that the “outlook remains subject to high uncertainty and substantial downside risks”. That said, a standard Taylor rule taking our growth forecast as an input suggests rates should stay around the current level during 2012 (see chart).

Which rate reflects the appropriate monetary policy stance?

One complicating factor in the current environment, however, is that it is not straightforward to say which interest rate – and hence which Taylor rate – appropriately reflects the stance of monetary policy. During ‘normal’ times, the spread between the ECB’s marginal refi rate and EONIA is small, and it is sufficient to focus on the refi rate. But this is not the case right now in an environment of dysfunctional money markets and the ECB’s full allotment liquidity regime, implying an EONIA rate that is trading close to the ECB’s deposit rate.

One could argue that EONIA reflects the willingness of banks to lend to each other overnight and that it is therefore the relevant interest rate when assessing the relative tightness or ease of monetary policy. But this is not necessarily the case given that there is now a much bigger than usual differentiation between stronger and weaker banks. Put differently, EONIA is only at best the relevant money market rate for a certain segment of the banking sector, while a significant part of the banking sector is not able to borrow at this rate. Thus, the funding costs for each group of banks are determined by a different money market rate and while the weaker banks are borrowing at the ECB’s refi rate, the deposit rate is probably the more relevant borrowing rate for the stronger banks.

What to do about the interest rate corridor?

This differentiation in money markets means the Governing Council needs to decide first what an appropriate weighted measure for its monetary policy stance would be. But the complexities do not end here. Due to the differentiation between stronger and weaker banks, the Governing Council also will have to make up its mind what to do with the interest rate corridor, i.e., where the deposit rate should sit relative to the refi rate, were it to conclude that further monetary stimulus via rate cuts is needed.

Another 25bp cut in the refi rate would bring the deposit rate – which is a much better indication of the funding costs for stronger banks than the refi rate - to zero, assuming the ECB left the corridor at 75bp. A deposit rate of zero may, however, create its own problems and it is no coincidence that in April 2009 the ECB narrowed the spread between the deposit and refi rates to 75bp from 100bp previously in order to avoid a zero deposit rate.

Narrowing the corridor between the deposit and the refi rates further, however, implies that the funding costs between the stronger and weaker banks are also reduced. To the extent that this spread is justified by economic fundamentals, a narrowing of the spread would imply a subsidy of the weaker banks relative to the stronger banks.

Monetary policy in times of a broken transmission mechanism and why non-standard measures are the preferred instrument

The ECB is well aware of all these difficulties and has stressed on several occasions that the monetary transmission mechanism is broken. Indeed, the official explanation behind the measures announced at the December meeting states that these are needed “to safeguard the effectiveness of the monetary policy transmission mechanism”. ECB president Draghi specified further in a speech at the end of December that due to an impaired transmission mechanism “the impact of a rate cut itself is weakened”.

The segmentation of the money market is thereby just one part of the transmission mechanism that appears to be damaged. Bank lending rates for the private sector also continue to show an unusually wide spread to the ECB’s refi rate, in particular when taking into account that, at least for some banks, the deposit rate represents the appropriate funding cost (see chart).


All this suggests, in our view, that further non-standard measures are more likely than another cut in the refi rate should the economic environment deteriorate significantly further. First, because it is not clear which short-term rate best reflects the monetary policy stance vis-à-vis the banking system. But, possibly more importantly, the ECB will want to ensure that the low level of short-term rates (be it the refi rate, EONIA, or the deposit rate) is actually passed on to the real economy before it cuts rates further.

These measures could include the announcement of further 3-year LTROs, a broadening of the acceptable collateral for ECB refinancing operations, or more direct purchases of non-sovereign debt, such as those currently conducted under the second covered bond programme. As far as the Securities Market Programme is concerned, however, it is reasonable to assume that the ECB believes that the ball is in the court of governments. Any change to the program would come only once more progress has been made on the fiscal front.