The decision by the European Central Bank to keep its key policy rates unchanged was widely expected, but markets were not entirely prepared for strong hints from ECB President Mari Draghi that policy may be eased further unless signs emerge relatively soon that the Euro area is stabilising and looks capable of delivering the modest recovery that the ECB envisaged would take hold in the second half of the year.
Concerns about the likely limited effectiveness of a further 25 basis point cut in the ECB’s refinancing rate and problems in finding a mechanism to improve access to credit across peripheral Eurozone economies mean a decision to ease policy further is not entirely straightforward. However, signs of a continuing deterioration in the most recent batch of survey data, indications that economic weakness was spreading to ‘core’ economies and broader policy problems with the Eurozone may force the Governing Council’s hand.
Any decision to ease policy is likely determined by the health or otherwise of the batch of short term indicators released in the next month or so. Back in May 2012, the ECB monthly report examined various short term indicators and suggested that two to three months’ data would be required to signal a change in trend. We have now had a sequence of poorer data through the past month or two. Evidence of a further deterioration in European Commission Sentiment data, in PMI indices and most importantly in surveys such as the German IFO and French INSEE may be sufficient to prompt ECB action as soon as the Governing Council’s next policy meeting on May 2nd unless there is very contradictory evidence in the form of unusual strength in ‘hard’ data such as upcoming production and spending numbers.
The change in tone from the ECB doesn’t signal a completely new departure in thinking although it may reflect some shift around the Governing Council table towards a more downbeat view of near economic term prospects. It likely also reflects a possibly reluctant acceptance in some quarters that a measure of policy support may be needed both to sustain a fragile economy and the even more fragile acceptance of ongoing Budget austerity in a range of countries.
We think four influences have combined to push the ECB close to the point of easing policy again. First of all, as noted by Mr Draghi today, economic weakness has spread beyond the troubled economies of the Euro area to the ‘core’ of late. The ‘shared’ nature of recent weakness argues that the overall policy stance of the ECB may need to be altered.
A second consideration for the ECB relates to the implications of recent difficulties in designing an assistance programme for Cyprus. A pre-emptive policy easing that improves the financial health of peripheral economy banks through cheaper ECB funding may appear altogether more attractive now than it did a month ago.
A third consideration is that in the face of disappointing economic data, the willingness and capacity of Euro area Governments to commit to continuing fiscal austerity is being questioned. In such circumstances, even modest policy action on the part of the ECB that suggests a sensitivity to the economic and political difficulties in sustaining multi-year adjustments would have much to commend it.
A fourth consideration for the ECB is the continuing weakness in lending aggregates and the consequences of that weakness for activity and employment. It should be acknowledged that a further 25 basis point rate cut would not make a dramatic difference to the economic outlook and we don’t expect the deposit rate to be cut into negative territory unless economic and financial conditions were to deteriorate sharply in the next couple of months. However, the combination of a cut in the ECB’s refinancing rate and the introduction of a new programme designed to accommodate national differences in lending might prove helpful in several ways.