ECB FACES HURDLE FOR MONETARY POLICY
With growth picking up only gradually and inflation likely to remain below target for the foreseeable future, it would be premature to rule out further monetary easing in the euro area. But following this week’s hawkish press conference, the hurdle for further action is probably higher than we thought.
We had thought there was a good chance that the European Central Bank (ECB) would cut interest rates at this week’s Governing Council meeting. In the end, though, it seems that data released over the last month have pushed the ECB further from easing than we thought and that the Governing Council did not give any serious consideration to a rate cut. Moreover, the tone of yesterday’s press conference was hawkish, suggesting that the probability of a rate cut in April is also lower than we previously expected.
The ECB’s explanation for not cutting rates this week was fairly straightforward. First, data released over the past month have tended to confirm its baseline forecast for a moderate but sustained recovery in euro-area output growth and, “by and large,” have been stronger than expected. Moreover, while the ECB still thinks the outlook is subject to downside risks, neither of the two contingencies that would trigger an immediate policy response—an unwanted tightening of money-market conditions or a sudden worsening of the medium-term outlook for price stability—has been met.
None of this is particularly surprising. What we did find surprising, though, was the renewed emphasis that the ECB put on the strength of recent survey data—like the composite Purchasing Managers’ Index, which reached a two-and-a-half year high in February (Display 1)—and the relaxed stance adopted towards persistently low inflation. Earlier this week, ECB president Mario Draghi warned that the longer inflation remained low, the greater the risk that it would not return to target in any “reasonable” time frame and that inflation expectations might become “disanchored.” Yesterday, the ECB left interest rates on hold despite the fact that its new staff forecasts show inflation below target for at least the next three years (Display 2).
Overall, the ECB now seems to be more confident that the recovery will push inflation back towards its target of “below but close to 2%” and no longer feels compelled to hasten this process. In our view, there are clear echoes here of the old, reactive, ECB from the pre-Draghi era.
Focus on Spare Capacity
We also detected an important change of tone when the ECB president was asked whether any of his colleagues wanted to ease policy this week. After saying that there had been a “broad discussion“on changes in interest rates and other policy tools, Draghi said that if he had to “flag a key point“ in the discussion, it was the importance that the Governing Council attached to the large amount of spare capacity in the economy. This, he added, would allow the ECB’s monetary policy stance to “stay in place” even after the economy had started to improve.
The focus on spare capacity was probably intended to reinforce the ECB’s forward guidance—that the Governing Council expects interest rates “to remain at present or lower levels for an extended period of time.” In our view, though, the underlying message is surprisingly close to the one currently being sent by the Bank of England. In other words, it sounds more like a central bank trying to manage its exit strategy than one thinking about injecting fresh monetary stimulus.
Given the speed with which the ECB cut interest rates in response to low inflation last November, the dovish inclinations of many Council members and the subdued nature of the recovery, we think it is too early to rule out further monetary easing in the euro area. Indeed, the ECB stressed again yesterday that it was willing to use “all instruments available to us” and that it would “take further decisive action if required”.
But following yesterday’s press conference, it looks as if the hurdle for further action is higher than we thought. With inflation set to hit a new low in March, a rate cut at April’s Council meeting is still possible. But the probability is lower than we thought and it may now require a more significant deviation from the ECB’s central forecast, or marked appreciation of the euro— which received particular attention at yesterday’s press conference—to trigger additional action. Moreover, barring a wholesale change in the outlook, the market’s hopes for more aggressive policy moves, such as quantitative easing, seem to be well wide of the mark.