June 02, 2014

Draghi Gets Ready to Go Negative as Inflation Sinks

Mario Draghi is preparing to lead the European Central Bank into the unknown. From negative interest rates to conditional liquidity for banks, the ECB president and his fellow policy makers have signaled all options are up for discussion when they meet on June 5.

Of the 50 economists surveyed by Bloomberg News, 44 expect the ECB to become the first major central bank to take interest rates into negative territory.

“We are ready to act,” ECB Vice President Vitor Constancio said yesterday. “We are not complacent about the risks from a protracted period of low inflation.”

The ECB is trying to head off the threat of deflation as the economy struggles to cope with the aftermath of a debt crisis that threatened at one point to blow up the euro.

Possible options include suspending the absorption of liquidity created by crisis-era bond purchases or re-purposing its offerings of unlimited cash in a way to encourage bank lending.

That would help address a credit squeeze that is still holding back a recovery in southern Europe.

“For monetary policy to produce its full effects, there must be no binding constraints on credit supply through the banking system,” Draghi said in a speech in Portugal on May 26.If banks don’t have the cash on hand to make loans, “monetary policy can play a bridging role,” he said.

Greatest Concern

The ECB is working on a proposal for a conditional longer-term refinancing operation and expects to have a plan ready for the June 5 meeting, according to a central bank official familiar with the plans. Details on the cost, maturity and the appropriate measure of credit supply have yet to be finalized, the official said.

The Financial Times yesterday cited unidentified people familiar with the situation saying that the interest rate on new liquidity offerings could be tied to banks’ willingness to lend to certain industries.

“If a set of measures is taken -- it’s still to be decided next week -- they will all go into the same direction,” Constancio said in an interview May 28 after the institution published its Financial Stability Review.

“The greatest concern we have as a central bank is indeed the possibility, the risk, that a prolonged period of low growth and inflation will create all kinds of risks.”

Deposit Rate

The ECB is likely to cut its deposit rate to minus 0.1 percent from zero at present, according to 32 of the economists in Bloomberg’s survey. Twelve more predicted a reduction to minus 0.15 percent.

Economic data in the coming days is also likely to reinforce the view that action is needed, with economists predicting they will show a grim mixture of a too-low inflation rate and unemployment (UMRTEMU) near a record.

A report on June 3 will probably show that inflation slowed to 0.6 percent in May from 0.7 percent in April, according to the median of 32 forecasts in a Bloomberg survey. That would leave it under 1 percent for an eighth month, well short of the ECB’s aim of keeping it just below 2 percent.

Unemployment data, due the same day, will probably show the jobless rate stayed at 11.8 percent in April, close to the record 12 percent reached last year, another survey showed.

“If you look at the broader array of economic data that is currently out there, then pretty much all of it points to the need for further stimulus,” said James Ashley, chief European economist at RBC Capital Markets in London.

“We’re looking at conventional and unconventional steps.”

Economic Forecasts

Draghi will also unveil new growth and inflation projections this week, which may determine how far the central bank is prepared to go.

The ECB forecast in March that inflation would average 1 percent this year and 1.3 percent in 2015. Goldman Sachs Group Inc. says it will probably cut its 2014 projection to 0.8 percent. The growth forecast for this year may also be lowered after the economy’s sluggish performance in the first quarter.

Bank of Italy Governor Ignazio Visco last week pointed to the importance of the new forecasts. “Inflation is expected to remain below 2 percent over the next two years,” he said on May 30.

“This is not consistent with our definition of price stability. If this pattern is confirmed, the Governing Council is determined to act, even with unconventional policies.”

Survey Reports

Inflation and unemployment statistics are not all that the Governing Council will have to digest this week. An update to first-quarter euro-area gross domestic product on June 4 will be published, showing how much or little consumers, governments and trade contributed to growth.

In addition, Markit Economics will publish its final readings for manufacturing and services. “They’ve telegraphed action,” said Jacques Cailloux, chief European economist at Nomura International Plc in London.

“The speculation is what will they do on top of the rate cut that’s looking like a done deal.” At the same time, ECB watchers are skeptical that officials are prepared to embark on a full-scale program of quantitative easing just yet.

In a Bloomberg survey last month, just 8 percent of economists forecast the ECB will start asset purchases, indicating they don’t see it following the Bank of England and the Federal Reserve down that road.

While a rate cut could weaken the euro and boost inflation, the more unconventional steps focused on boosting credit and helping the implementation of policy will be more important in terms of the impact on the economy, according to Cailloux.

“None of the measures we expect the ECB to take would be game-changers,” said Marco Valli, an economist at UniCredit SpA in Milan.

“But they would help at the margin, especially any funding-for-lending-type move as the transmission of monetary policy is the ECB’s biggest challenge at the moment.”

bloomberg.com

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