Fundamentals April 30, 2013

June 05, 2014

With market expectations so high for action, the European Central Bank has no choice but to loosen its monetary policy on Thursday, economists said.

Economists expect the central bank to cut its main refinancing rate by 10 or 15 basis points — bringing the rate down to 0.15% or 0.10% — and to introduce a negative deposit rate of 0.1%. Additionally, economists also expect the ECB to stimulate more lending by creating a new long-term refinancing operation.

Some economists also believe there is the possibility that during the press conference, ECB President Mario Draghi will keep the door open for outright quantitative easing and asset purchases later in the year.

The only option the ECB doesn’t have is to do nothing, they said.

René Defossez, fixed income strategist at Natixis, said since the May monetary policy meeting, central bank members “have made a lot of promises,” which have helped push the euro down against the U.S. dollar, easing some of the pressures on the European economy. He added it would be a disaster if the ECB didn’t follow through with those promises.

 “If they didn’t cut rates you would see the euro at $1.45 a minute later,” he said. “That is not something the ECB wants to see.”

 Simon Ward, chief economist at Henderson Global Investors, agreed that it seems unlikely the ECB will stand on the sidelines at Thursday’s meeting. He added the central bank has been forced into this position because of a stronger euro and they don’t want to undo all the work that has been done in the last month.

Not only has the euro remained stubbornly high against the greenback, but inflation continues to remain weak and there remains a growing risk of deflation.

 On Tuesday Eurostat, the EU statistics office, said the consumer price index fell to 0.5% in May, down from April’s reading of 0.7% and well below the central bank’s target of 2.0%. Economists expected inflation to remain stable at 0.7%.

 “Inflation is definitely a cause for concern right now for the ECB,” Defossez said.

 Although the ECB has to act, economists also question how effective the ECB’s tool will be in combating low inflation, promoting growth and encouraging banks to lend more money. Defossez said he doesn’t think the central bank’s options will have a long-term impact on any of these fronts.

Defossez added that in 2012 Denmark’s central bank introduced a negative interest and in 2010 so did the Swedish central bank, with questionable results.

He added if the ECB really wanted to stimulate the economy they would introduce a form of quantitative easing or an asset-purchase program, but this is unlikely.

Benjamin Reitzes, senior economist at BMO Capital Markets, agreed that a 10 or 15 basis point cut in interest rates won’t have much of an impact. However, the ECB has to do something and because they are in uncharted territory they are going to be taking “baby steps,” he said.

Although negative rates sounds like a good motivation for banks to lend out money, Reitzes said that it is still not much of an incentive. He added if banks are unable to take the risk of lending money at 8% then they are probably willing to take 0.1% hit on their deposits, which is a relatively low amount.

“We are talking about tens of millions of dollars instead of hundreds of millions of dollars,” he said. “The central bankers are doing what they are able to do. That is all you can ask of them. What they need is reform from other government in the eurozone.” Source: Forbes/Kitco News

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