All eyes are once again on Mario Draghi, hoping he can perform his magic and get a white rabbit out of his hat. Slowly but surely, the ECB has reached the point at which additional action could potentially do more harm than good. However, for the time being the ECB considers inactivity the worst of all options and will, in our view, present a mix of smaller, but above-consensus, measures. We see it as a rather a parlour trick than a white rabbit.
Waiting for the slowdown. To give the ECB some credit, the concerns voiced at the January meeting were justified. Since the January meeting, the Eurozone economy has actually done what the ECB had feared and has been slowing down. Confidence indicators have taken a substantial hit and both headline and core inflation have come down. Even though the only hard data available so far for January (retail sales) was positive, the Eurozone economy appears to be suffering under a weaker external environment and political uncertainties in a couple of member states.
Staff projections should confirm weaker outlook. Special focus will be on the latest ECB staff projections next week, not the only one but clearly one of the most important elements for the ECB to decide on further action. Back in December, the outlook for both growth and inflation was relatively stable, tilted to the positive side. The weaker external environment and the drop in confidence indicators since then have made a downward revision of both the growth and inflation projections very likely. In our view, the key forecast for ECB policy-making will be the inflation forecast. Just looking at the external assumptions of oil prices and the exchange rate, the further drop in oil prices and the appreciation of the nominal effective exchange rate could easily shave another 0.3ppt off the December inflation forecasts (1.0% for 2016 and 1.6% for 2017).
New action could bring negative risks. With faltering growth momentum, another downward revision of the inflation outlook, and echoes of Mario Draghi’s comments at the January meeting, the ECB will likely have no option other than to announce more monetary stimulus. As illustrated in the minutes of the January meeting, the ECB under Draghi is determined to rather act pre-emptively rather than stick to a wait-and-see stance. However, finding the right instruments has never been more difficult than at the current juncture. In fact, the ECB has almost come to the point at which more action could potentially do more harm than good. Particularly, this holds for a further lowering of the deposit rate. Being the new focus amongst central bankers, negative interest rates are supposed to weaken the exchange rate. This channel worked last year but is unlikely to work this time around as the fate of the euro-dollar exchange rate is currently almost exclusively determined by the Fed. Only a positive surprise could revamp this channel. At the same time, a further cut in rates could have adverse effects on the banks. Negative interest rates are hurting bank profitability, putting more pressure on cost cutting and eventually bringing banks into more problems.
Inactivity the worst option. Despite increased risks related to further action, inactivity seems the worst option for the ECB. We think Draghi will deliver a mix of several small, but above-consensus, steps: a 20bp deposit rate cut, either two-tiered or with some other compensating measures for the banks, a broadening of QE scope and a 5bn euro increase in monthly QE purchases. On top of all, some verbal intervention suggesting that the ECB would tolerate overshooting of the inflation rate would also help to prop up inflationary expectations.