Thursday, November 7, 2013

Another big-bang-pulling-out-all-the-stops day in Frankfurt

Never a dull moment. The ECB surprised most analysts, including us, by cutting its refi rate by 25bp to now 0.25%. At the same time, the ECB left the interest rate on the deposit rate unchanged at zero, while cutting the rate on the marginal lending facility also by 25bp. In addition, the ECB announced to keep the liquidity tap open at least until mid-2015. It is all about inflation. While the ECB has been concerned about the economic outlook for a long while, today’s rate cut was purely motivated by what ECB president Draghi called a changed outlook for inflation. According to the introductory statement, the ECB is now expecting that “we may experience a prolonged period of low inflation, to be followed by a gradual upward movement towards inflation rates below, but close to, 2% later on”. Back in October, the ECB said that its forward guidance was conditional to “an unchanged overall subdued outlook for inflation”. According to Draghi, the outlook for inflation had changed over the last four weeks, thereby justifying today’s rate cut. The decision was not unanimous, at least not on the timing. Finding the changes to the inflation outlook, however, is not easy. The latest business and consumer survey from the European Commission actually showed an increase of inflation expectations. At the same time, the latest Commission forecasts, released on Tuesday, showed a stable forecast for Eurozone headline inflation around 1.4% until 4Q15. Remarkably, even if the ECB today noted that “inflation expectations for the euro area over the medium to long term continue to be firmly anchored in line with our aim of maintaining inflation rates below, but close to, 2% later on. The only thing which really has changed over the last four weeks is actual headline inflation. It looks as if the headline inflation drop in October to 0.7% YoY had a stronger impact on the ECB than we had anticipated. Interestingly, the euro exchange rate did not play a role in today’s decision. At least not officially. The exchange rate does not appear in the introductory statement, neither as a risk to the economic outlook nor as a risk to inflation. As regards the regular assessment of economic developments, the ECB still expects a gradual recovery with risks to the downside. These risks continue to be developments in global money and financial markets, but also higher commodity prices and “slow or insufficient implementation of structural reforms”. Maybe as an effort to strengthen the impact of today’s rate cut, the ECB also announced to extend all refinancing operations with full allotment at least until mid-2015. All in all, it looks as if many professional ECB watchers have to look for some freshening-up training. The ECB under Mario Draghi has become much more pragmatic and pro-active than under any of Draghi’s predecessors. Contrary to past experiences, the ECB now seems to follow the motto of “even if it does not help, it does not hurt either”. However, the long-term consequences of today’s decisions remain unclear. On the one hand, it increases the ECB’s reputation as the Eurozone’s pro-active fire fighter, while on the other hand it is a hit to the ECB’s predictability, eventually making future forward-guidance and market expectation management more complicated. It is doubtful that today’s decisions are really a crucial strike against deflationary trends in the Eurozone. Even the weakening of the euro exchange rate could turn out to be short-lived in the absence of further action. In fact, on-going deleveraging in both the private and the public sector should exert further deflationary pressure which will be hard to tackle by monetary policy. Let’s not forget that there have been more of these pulling-out-all-the-stops days at the ECB over the last years with cheerful reactions on financial markets but limited impact on the real economy. Even if Draghi reiterated that the zero bound for interest rates had not been reached, we are doubtful that the ECB can still offer many of these big-bang days in the future.

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