Crunch Time For The ECB

For the last few months we have argued that the issue of deflation in the eurozone would come to a head in 2014. Either inflation stabilises across the bloc, or disinflation transitions into deflation, in which case the European Central Bank (ECB) would be forced to intervene heavily to stop the rot. With headline inflation lingering below 1.0% y-o-y for the past four months, and with the most recent print coming in at 0.7% y-o-y in January, crunch time is looming for the ECB. In addition to deflation risks, we continue to highlight the threat posed to financial stability from passive monetary tightening. The chart below shows the decline in excess liquidity at the ECB, which in the past has triggered volatility in secured and unsecured lending rates. With excess liquidity already at extremely low levels, the money markets are starting to rumble.

While there is generally consensus for further monetary stimulus this year, there is some disagreement as to what form this will take. The EURIBOR futures market has priced in a 25bps cut to the refinancing rate at tomorrow's (February 6) monetary policy meeting, which would leave the main policy rate at zero. The chart below shows the distribution for EURIBOR-implied policy rates through to September and indicates that the market is positioned for lower rates. Although we cannot completely discount the possibility of such a move, we believe that at this stage in the cycle a 25bps cut to the refinancing rate would have limited impact on the broader economy and prices. Until the credit transmission channel is restored and credit to the private sector recovers, modest reductions in bank funding costs will not fully flow through to borrowers.

As such, our forecasts still foresee rates bottoming at the current level of 0.25% (though downside risks to this projection are significant), and we expect the ECB to focus on other forms of monetary intervention. A negative deposit rate is still a possibility if prices plunge sharply into deflation territory, as is some form of watered down quantitative easing, though the former comes with risks to financial stability and the latter would set the ECB on a collision course with the German constitutional court. These more extreme policy measures would only be deployed as a last resort, with the central bank likely to pursue softer alternatives in the first instance. Indeed, we see scope for small scale LTRO top-ups (in our view, banks would be reluctant to absorb another EUR1trn in LTRO funds at a time when the Asset Quality Review is underway), modest credit easing measures and use of forward guidance.

A Red Flag
Eurozone - ECB Excess Liquidity & EONIA

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