- We now expect a 25 bp refi rate cut in December
- We expect a clearly dovish tone at this week’s meeting
- Liquidity will remain ample
We change our forecast and expect a 25 bp refi rate cut in December to 0.25%
Risks have been clearly biased towards additional ECB easing recently and we believe the October inflation reading was enough to tip the balance. Thus, we now expect another 25 bp cut in the refi rate – probably in December.
Inflation dropped to 0.7% in October, according to the flash estimate, and thus adds a few worries to the already long list. The new staff projections – which will be presented at the December meeting – will show an even lower inflation projection for 2014 due to the lower starting point and the stronger EUR. Moreover, the low inflation reading may be another indication that the ECB has underestimated the size of the output gap, thus increasing the risk of deflation. Lastly, the 2015 inflation projection will be new and is likely to be fairly low (1½%) compared with the “close to but below 2%” target and thus risks affecting medium-term inflation expectations.
The list of worries was long even before the surprisingly low inflation reading. Excess liquidity dropped below 200bn for the first time since the introduction of the two 3-year LTROs; the EUR has strengthened steadily against the USD, at least until the inflation surprise; and some banks talk about a liquidity cliff approaching as the remaining maturity of the LTROs becomes less than one year. On top of all this come the Asset Quality Review and the subsequent stress tests, where the ECB will need to build credibility as a tough financial supervisor.
We expect a clear dovish bias at this week’s meeting
There is little doubt that Mr Draghi will be very dovish at this week’s meeting. We believe the balance has tipped in favour of more easing, but uncertainties regarding timing and tools are substantial. Therefore, the ECB may not be ready to give clear signals about an upcoming refi rate cut this week.
When the ECB cut its refi rate in May, Mr Draghi “pre-announced” the decision in April by saying that “In the coming weeks, we will monitor very closely …” At that point, the ECB probably knew that unless more action was taken, the inflation projection would have to be revised down substantially in June. Moreover, the April flash inflation reading surprised significantly on the downside (1.2% compared with Bloomberg consensus of 1.6%). The three other refi rate cuts in the Draghi era (November and December 2011 and July 2012) were not pre-announced.
Moreover, in May and June 2013 the ECB also kind of “pre-announced” additional easing by saying that “In the period ahead, we will monitor very closely…” However, at the June meeting no actions were taken and at the July meeting the Governing Council decided to do an ECB version of forward guidance. A Spiegel article later suggested that forward guidance was a compromise. It is not completely unlikely that the ECB could chose to strengthen its forward guidance framework instead of cutting the refi rate, if it turns out to be the path of least resistance.
Thus, whether Draghi says “monitor very closely” at this week’s meeting or finds other ways to signal the ECB’s clear easing bias, we believe that markets will be looking for more ECB easing in December.
Liquidity to remain ample
The ECB is working for ways to prevent a liquidity cliff when the current 3-year LTROs expire. Our long-held view is that the ECB will not do a new LTRO, but that liquidity will remain ample. Several Governing Council members have suggested that the ECB is working on something in terms of liquidity, which may or may not be a substitute for a refi rate cut, and this adds uncertainty to our new forecast and to the signals coming from Mr Draghi this week to the extent that the technical conclusions are still pending.
A narrow majority of money market traders expect a new LTRO, according to a Reuters poll released last week, and the ECB could also free up liquidity by not sterilising its assets held as part of the Securities Markets Programme (SMP). Apart from the possibility to add additional liquidity to the markets, the ECB could be working on other measures to alleviate concerns about a liquidity cliff.
In May, the ECB announced that liquidity provisions will be unlimited for as long as needed and at least until July 2014. The ECB could extent that to January 2015 or even July 2015.
No matter what the ECB has in mind on the liquidity front, we expect liquidity to remain ample, and we expect the ECB to keep all doors wide open, including the possibility of new LTROs, in the months ahead.
Conclusion: timing and tools are uncertain, but more easing is likely
All in all, timing and tools are uncertain, but more easing is likely.
Activity indicators are showing weakness, but partly because of the US shutdown, and inflation is too low, but partly due to base effects and volatile components. Thus, the ECB may want to see just one more month of numbers before deciding on the right tool for the job, which means that the timing is uncertain and probably not November.
All tools are likely to be on the table, including a refi rate cut, forward guidance, new liquidity measures and a negative deposit rate. The ECB’s technical work on the banks’ liquidity needs may be crucial for the choice of tools, which means that the combination of tools is uncertain until the technical work is done.
Still, we believe that the pressure on the ECB to act is too big for the bank to resist. We believe a refi rate cut is the mostly likely tool and we believe that the December meeting is the most likely timing.
Nordea