• No major change in economic assessment but readiness to act emphasised
  • Comments suggest ECB could act further if outlook deteriorates markedly
  • Draghi’s verbal easing intended to encourage supportive market conditions
  • Details of TLTRO’s and question of tiered deposit rates now being examined…
  • …Settings could differ notably depending on economic developments
  • New ECB working papers highlight factors arguing ‘lower for longer’ for rates

Yesterday’s policy meeting of the ECB’s governing council was widely expected to be a holding operation. It is not in the nature of the ECB to surprise markets twice in a row and the March policy meeting saw the ECB signal a more dovish policy outlook than had been anticipated. More fundamentally, in what is a very uncertain economic and financial market climate at present, it didn’t seem likely that Mr Draghi would pre‐commit significantly in terms of the details of future adjustments to policy settings.

Work in progress … ready by June?

In the event, Mr Draghi showed his dovish nature to a greater degree than had been envisaged in several respects with the result that Euro area market rates softened in the wake of his comments. While he didn’t provide specific details of prospective policy measures, he indicated that the technical terms around the upcoming Targeted longer Term Refinancing Operations (TLTRO’s) announced in March ‘… will be communicated at one of our forthcoming meetings.’ More importantly, he stated that ‘…we will also consider whether the preservation of the favourable implications of negative interest rates for the economy requires the mitigation of their possible side effects, if any, on bank intermediation

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Finally, if more open to interpretation, a dovish slant to these commitments might be inferred by the greater prominence in the ECB’s opening press statement given to the indication that ‘The Governing Council stands ready to adjust all of its instruments, as appropriate, to ensure that inflation continues to move towards the Governing Council’s inflation aim in a sustained manner’. While this wording has appeared consistently in ECB press statements since June 2018, it hasn’t usually been given the prominent positioning or separate paragraph it received in yesterday’s statement. Instead, it has usually appeared at the end of paragraphs outlining how monetary accommodation would continue to support activity.

ECB able and willing to act further

The increased prominence given to a readiness ‘…to adjust all of its instruments, as appropriate…’ is not down to random word sequencing. By signalling it is able and willing to use its full ‘toolbox’ of policy instruments to ensure inflation converges towards its target, the ECB is adding a more dovish tilt to its forward guidance and undertaking additional ‘verbal easing’.

To emphasise this shift, Mr Draghi noted that the council meeting while reiterating confidence in the inflation path also reasserted a readiness ‘to use all the instruments necessary to cope with the contingencies to come ahead and this was I would say unanimous’. Mr Draghi later added that yesterday’s meeting ‘was not an operational meeting. It was more of a meeting that would characterise the stance of the governing council towards further action… the main goal of which was to reassert the readiness to act if the contingencies would warrant so.’

This is not to say that the ECB will introduce any measures in coming months to make its stance significantly more accommodative but by clearly signalling such a possibility if it is required, Mr Draghi will hope to encourage markets to price in such an outcome. In this context, he asserted that ‘the market reaction to my ECB watchers speech ..shows that we have plenty of instruments..and markets have fully understood our reaction function.’

Mr Draghi continues a verbal easing

The rationale for a measure of ‘verbal easing‘ is partly a reflection of what Mr Draghi said was a meeting that focussed attention on assessing an outlook ‘which is a picture of weakening growth’ although there was relatively little discussion of the current health of the Euro area economy in the Q&A session and little material change in the press statements description of the economic climate. Moreover, Mr Draghi suggested the probability of a recession remained low.

Mr Draghi did suggest that yesterday’s meeting re‐asserted confidence that inflation would move onto a path consistent with the ECB’s target although he also indicated the headline inflation rate for the Euro area might not reach a low‐point until September. Importantly, however, when asked about the recent drop in the five year‐five year inflation swap rate, a market gauge of inflation expectations, Mr Draghi noted that the ECB’s analysis indicated this was predominantly because of ‘a negative risk premium’ that might reflect either perceptions of either a lack of instruments or a tolerance for persistently below target inflation on the part of the ECB. Mr Draghi refuted either possibility.

Our sense is that both of these explanations might argue for the verbal easing we saw particularly in circumstances where there has been increased focus on the potential threat of what is termed the ‘Japanification’ of the Euro area economy entailing the threat of a prolonged period of weak economic growth and downward rather than upward pressure on prices.

Mr Draghi emphasised on a number of occasions that yesterday’s governing council meeting didn’t discuss specifics in relation to the terms applying to upcoming TLTRO’s and that they hadn’t gone beyond setting in train an analysis of the potentially contentious issue of ‘the mitigation of ..possible side effects, if any, on bank intermediation’ of negative interest rates. However, he did repeat that markets understood the ECB’s reaction function which implies he could envisage reactions in terms of both the future level of market rates and shape of the yield curve in the Euro area as well as the FX value of the Euro.

What might come next?

There is a significant likelihood that, unless economic conditions improve materially, markets may begin to anticipate measures that constitute a notable further easing in ECB policy in the months to come. One element of this would be that when the interest rate to apply to the TLTRO’s is finally announced, it will be markedly more attractive than the 25 basis point premium over the ECB’s refinancing rate that newswire stories suggested had been initially proposed at a technical level within the ECB (but rejected by policymakers as too high).

There could be notably greater speculation and an even greater range of suggested outcomes in relation to ‘mitigants’ to the impact of negative rates on bank, which is set to debate the possibility of tiered ECB deposit rates that would translate into reduced average costs to commercial banks with significant excess reserves.

The impact of negative rates on the Euro area banking sector has been a much debated issue. Previous ECB analysis has emphasised the complexity of factors likely to determine the balance between a range of benefits running from increased lending volumes, improved credit quality and capital gains on bond holdings against costs associated with a flatter yield curve and ‘sticky’ nominal deposit rates.

While much of this analysis emphasised initial benefits from an improving environment, Mr Draghi acknowledged that the nature and magnitude of benefits and costs would be different at the start of the process and when it was in place for a long period of time. He also noted that ‘the way it affects different institutions was profoundly different’. Consequently, it might be expected that the associated analysis would be quite a complex and possibly protracted process.

When asked if the introduction of measures that might mitigate any adverse impact on commercial banks of negative rates might mean the ECB could have scope to cut rates further, Mr Draghi said that discussions hadn’t even begun on the broader issue of whether such mitigating measures might be warranted. Again, however, depending on economic developments in coming months, market attention might turn to the possibility that the introduction of tiered deposit rates could lessen commercial bank sensitivity to the implementation of a drop in what would then be the marginal deposit rate further into negative territory.

It should be emphasised that such action appears only a remote possibility at present as any policy measures to test the lower bound for interest rates would require a marked further deterioration in economic conditions and an associated fall in the inflation outlook. However, the fact that it might even be mooted as a possibility gives some sense of the ‘negative risk premium’ now seeping into market thinking.

Arguing for accommodative policy

Our sense is that Mr Draghi tried today to reinforce market perceptions of an ECB shift to a more dovish stance and attempted a further verbal easing. It would not be surprising if there wasn’t unanimous support for such an approach on the governing council. Hence, we may see some variations in the tone of comments from ECB officials in coming weeks. That possibility and a still unclear economic outlook that may throw up some surprising readings from economic indicators implies the prospect of choppier conditions in Euro area interest rate markets before the ECB’s next policy meeting in June.

Our sense that the ECB has moved to a somewhat more dovish position on the outlook for policy is clearly a reflection of a still threatening economic outlook. However, we think structural as well as cyclical factors may also be prompting a rethink of what ‘lower for longer’ might mean in terms of the outlook for rates. In this context, a couple of ECB working papers released in late March focus attention on longer term determinants of interest rates.

One examining the role of demographics (Demographics and the natural real interest rate: historical and projected paths for the euro area, WP2258), emphasises lasting downward pressure on interest rates from an ageing population. Another (Taylor‐rule consistent estimates of the natural rate of interest, WP 2257) compares new estimates of the ‘natural’ or equilibrium interest rate for the Euro area with those from a variety of studies. As the diagram below illustrates, the ‘real’ or inflation adjusted estimates vary significantly from study to study but a there is clear common ground in emphasising the substantial degree of monetary stimulus that the Euro area is estimated to require. This could be feeding into ECB thinking on how much longer and shallower the path to rate ‘normalisation’ might be.

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