ECB In Focus
“If inflation is the genie, then deflation is the ogre that must be fought decisively“- Christine Lagarde
Next Thursday should prove to be an exciting week for EUR/USD specs. The ECB Governing Council is widely expected to turn dovish and deploy its latest bazooka to fight the “deflation ogre” threatening to plunge the EU into a Japan-style “Lost Decade”. In recent weeks, talks of a Euro style QE have even been raised, highlighting the very fact that we live in an unprecedented age of the central bank (CB). In this post, I will analyze the various monetary policy tools the ECB has at its disposal as well as preview possible outcomes from June’s ECB meeting.
Why Is Deflation Bad?
One big reason is debt. Holders of debt become worse off over time as deflation increases the true value of what they owe. While the ECB has been a lot more prudent with its monetary policy actions than the Fed, a higher debt load would presumably limit the scope of monetary policy tools available.
Secondly, deflation incentivizes cash hoarding as the real return on cash now increases, in turn decreasing the risk adjusted return on assets. This shifts the focus away from investing into saving, creating a negative net effect on economic activity. As a result, an economy may plunge into a “liquidity trap” where monetary policy is rendered ineffective because increasing the money supply no longer has any impact on interest rates. This seems to be precisely what prompted Japan’s plunge into the “Lost Decade” from 1991-2000.
Thirdly, the lowering of inflation expectations may convince consumers to postpone their spending, creating a vicious circle where consumers expecting lower prices in the future limit spending, which in turn lowers prices and inflation expectations, stagnating the economy. Anchoring inflation expectations has thus become key, prompting the emergence of forward guidance as a key policy tool in recent years.
What the ECB can do- From plain vanilla to the unconventional to the extraordinary to the mythical
The Plain Vanilla
Refinancing/repo rate- This is the official policy rate, used for 1 week repos. Or as the ECB describes, “the interest rate which banks do have to pay when they borrow money from the ECB”. Because the refi rate has a significant impact on the EONIA (Euro OverNight Index Average), it has emerged as a key ECB policy tool (although it must be noted that the transmission mechanism has come under intense scrutiny of late).
Deposit rate- The overnight rate charged to banks for deposits with the ECB.
Marginal lending rate- The overnight rate for collateralized borrowings from the ECB. Typically 75bps above the deposit rate.
The Unconventional (OMOs)
Main refinancing operations (MRO)- Weekly collateralized refinancing operations.Conducted at the refi rate with full allotment (borrower may receive any amount sufficiently backed by collateral)
Special term refinancing operations (STRO)- Monthly operation with a maturity of 1 maintenance period (36 months). Conducted at the average refi rate, full allotment
Long term refinancing operations (LTRO)- 3 month/ 3 year operations at average main refi rate, full allotment
The Extraordinary
FX Swap Facility- Sells specified amount of currency to foreign CB, foreign CB must buy back currency in the future at the exchange rate used in the initial leg. Fixed rate, full allotment, large haircuts applied. Discontinued in Jan 2010.
Covered Bond Purchase Program (CBPP)- The purchase of covered bonds (corporate bonds deemed safer due to collateral) by the ECB across primary and secondary markets. CBPP1 ran from Jul ’09 to Jun ’10, CBPP2 ran from Nov ’11 to Oct ’12.
Securities Market Program (SMP)- ECB’s bond buying program. Similar to the Fed’s QE with one key difference- sterilization using 1 week term deposits. In other words, every euro the ECB spends on bond buying is offset by withdrawing an equivalent amount of deposits. As Trichet remarked, “We are not printing money. This confirms and underpins our commitment to price stability”
The Mythical
Outright Monetary Transactions (OMT)- Yet another of the ECB’s bond buying schemes with the key difference being the targeting of the front end to bring down borrowing costs. Like the SMP, purchases are fully sterilized. The OMT was never implemented and will likely remain the stuff of legend after the German Constitutional Court’s verdict that “it exceeds the ECB’s monetary policy mandate”.
What will the ECB do?
1. Refi rate cut 15bps- The most likely move considering Draghi’s last statement that “the governing council is comfortable with acting next time”. A 10-15 bp cut seems to be the consensus and has likely been priced in by markets. A 15 bp refi cut however would likely be seen as symbolic at this point, with the real kicker being a negative deposit rate. Should the ECB fail to cut the refi rate however, its credibility could suffer a major blow. Given the increasing relevance of forward guidance, Draghi is unlikely to pass up the opportunity to reinforce guidance, placing the probability of a 15bp cut around 80-90%.
2. Deposit rate cut 15bps- A 15 bp cut from the current 0% rate would bring the deposit rate negative and into largely unexplored avenues with the exception of the Riksbank and Nationalbanken in Scandinavia. Why a 15bp cut? Indications are that the Governing Council will want to keep the interest corridor constant and hence, a 15bp cut in the refi rate will be followed by an equivalent 15bp cut in the deposit rate. Lower deposit rates should bring the EONIA lower as well and spark more interbank lending with the periphery. The focus in both cases of rate cuts is really the periphery. Since they are net borrowers as opposed to the core countries which hold excess reserves with the ECB, negative deposit rates should spark an outflow of these excess reserves from the ECB back into money markets. Lower rates also go a long way toward addressing a strengthening Euro. Overall, the benefits from a negative deposit rate skews the event probability to the upside at 80-90%
3. LTRO targeted at SMEs- While the last LTROs were focused on ailing banks, a new LTRO might be implemented to address rising borrowing costs for SMEs in the Euro area. For instance, the ECB may require corporate loans as collateral, increasing the demand for corporate credit and hence, bringing down corporate yields. An unconventional move like this seems unlikely at this point given the implementation of negative deposit rates. Furthermore, the addition of corporate loans to banks’ balance sheets may lead to adverse selection troubles and higher NPLs. Given the complications involved with implementing a targeted LTRO, I highly doubt the ECB will unveil this one in June. A much lower probability of around 20% would seem appropriate in this case.
On balance, next week’s meeting could prove to be a game changer for the ECB. With Draghi having managed expectations so well thus far, his commitment to action in June is likely to spark an unprecedented new venture into negative rates but not much else. Any extra measures could signal a good opportunity to re-open short positions in the EUR/USD, anything less and I’d wait on the sidelines.
