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No Change in the ECB Outlook despite Ambiguous Signals to the Contrary



Despite another month of disappointing inflation numbers, with euro area inflation dipping to 0.5 percent in the March flash estimate , the European Central Bank (ECB) will probably not take any further monetary policy easing action this week, for several reasons.

First, the ECB remains wedded to its new 3-year economic outlook published last month, which bullishly predicted 1.7 percent harmonized index of consumer prices (HICP) inflation for the euro area by the end of 2016. Like the Federal Reserve, locked in on its quantitative easing reduction path, the ECB is unlikely to change course without a substantial unforeseen deterioration in the euro area economy.

Second, the ECB is an ultra-independent federal (e.g., one country, one vote) single central bank overseeing a monetary union, where 18 national member state governments otherwise control most economic levers. But they have no control over the central bank, giving the ECB a structural bias against monetary policy activism. Frankfurt will not want to ease pressure on euro area governments to take tough domestic and regional institutional reform decisions. It might be argued that some countries in the euro area periphery have acted to assuage ECB concerns, but the adequacy of such steps is still uncertain for France and Italy, which constitute nearly 40 percent of the euro area economy. The ECB Governing Council is thus not likely to be in a generous mood anytime soon, even though euro area politicians have delivered a compromise over the single resolution mechanism (SRM) for failing banks that was close to the ECB's request.

What, on the other hand, about the latest ambiguous public comments from members of the ECB Governing Council? These comments suggested a desire to employ negative deposit rates in an attempt to weaken the euro's value, which Mario Draghi, the ECB president, has said is an increasingly important element of the euro area's inflationary outlook. If the euro were to rise much above $1.40/€ (or another increase in the trade-weighted value of the euro), it seems likely that negative deposit rates would be the first thing the ECB would try if necessary.

In truth, the central bank is unlikely to act. Instead it will focus on "improving communication" even while sowing doubts among market participants with ambiguous oral interventions.

But would negative deposit rates work? They proved effective in Denmark at stopping hot money inflows in mid-2012, eliminating the need for the Danish Central Bank to intervene in the financial markets to maintain the Danish peg to the euro . But it is far from certain that they would help to drive down the euro without a reduction to zero in the main refinancing rate. At least euro area central bankers are honest enough to acknowledge that negative deposit rates are under consideration with an eye on the exchange rate, rather than on stimulating lending in the real economy. The latter channel will not work. The amount of liquidity parked by euro area banks overnight at the ECB's deposit facility has dropped from almost €800 billion at the peak of the crisis to €30 billion. Thus negative deposit rates (+ main refinancing rate at zero) perhaps could stem increases in the euro's value, rather than drive its value back down. As they may ultimately have a quite limited effect, the ECB Governing Council is not likely to want to take the risk going to negative rates, as their credibility if they failed to drive down the euro would be dented, and commentators would immediately clamor for more forceful interventions. As seen from Frankfurt, it is safer to rely on the rhetoric that the ECB could act, if required. Accordingly, negative deposit rates are not—in the absence of further rises in the exchange rate—likely to be on the Governing Council agenda in the short run.

Many commentators accustomed to the activist monetary policy of the Federal Reserve, Bank of England, and Bank of Japan may despair at what they see as this continuing inaction from the ECB. Hand-wringing about the ECB being behind the curve and oblivious to deflation is inevitable. But just because the ECB isn't doing what others did earlier in the crisis doesn't mean that nothing beneficial is happening.

The ECB will surely look at sovereign debt markets and wonder why it should do more. Greek 10-year yields are below 7 percent, with spreads with Germany back at precrisis levels. Spreads in Portugal are below 300 basis points. Spain, Ireland, and Italy are below 200 basis points. Barring any abrupt reversals, why should the ECB launch a major government bond purchase program now? Last week the Bundesbank president, Jens Weidmann, surprised some people by not dismissing the possibility of future purchases, but he effectively ruled it out when you read the fine print.

Another factor in the thinking at the ECB is that it is busy dealing with another headache: its "asset quality review" (AQR)/stress test exercise, which Draghi has characterized as a structural regulatory answer to the fragmentation of euro area members' lending rates to the nonfinancial sector. Assuming the AQR succeeds in removing counterparty risks from banks that pass the exercise, the stress test exercise should deliver a sizable monetary stimulus to the periphery, because banks there could again access funding and pass through lower rates to borrowers.

Sensing that the credit cycle in the euro area is turning, some banks will likely resist having to write down or sell off their nonperforming loans (NPLs) and raise new capital right now. They will no doubt expect or hope that these NPLs will gradually return to health as the economy recovers. The euro area's new regulatory watchdog must reject that thinking. The banks should be forced to make the necessary corrections and raise enough capital to succeed. Indeed, rising prices of distressed asset prices in Europe should speed this process up.

As argued earlier on RealTime, the ECB will not be in a hurry to act before the AQR/stress process is completed in October. Only if the AQR fails to reduce fragmentation in lending rates among euro area members will the ECB likely intervene by using its balance sheet to purchase private bank assets to shore up the banks and encourage them to lend. But such a step is not likely until much later this year or in 2015. For the time being, the ECB will remain on the sidelines.

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