Friday 23 August 2019

Five reasons the ECB should hold fire on rate cut

European Central Bank policymakers have plenty of reasons to wait until September before committing to more stimulus (stock photo)
European Central Bank policymakers have plenty of reasons to wait until September before committing to more stimulus (stock photo)

Carolynn Look

European Central Bank policymakers have plenty of reasons to wait until September before committing to more stimulus. In the run-up to their meeting yesterday, governing council members had said that additional support measures are available, if needed, to boost the eurozone's ailing economy.

Traders in money markets are currently pricing roughly a 30pc chance of a 10 basis point cut in the deposit rate. Most economists, though, expect officials to adapt their policy language first to hint at lower interest rates, before following through at the subsequent meeting in September with a reduction and a pledge to restart asset purchases. The following arguments favour waiting until after the summer break.

The ECB's counterpart in the US looks primed to lower interest rates by a quarter percentage point next week, in its first reduction in borrowing costs in more than a decade. Investors were previously pricing in a larger cut before some policymakers pushed back against such a step, amid still-resilient economic data. Should the Federal Reserve surprise with an aggressive move or signal the start of an easing cycle, the euro could appreciate.

That would put downward pressure on eurozone inflation and dampen exports, enfeebling the economy even more. It may be worth waiting to see what US officials do to formulate a response, particularly because the ECB has less room to lower interest rates.

An economic report yesterday showed the slowdown worsening in July, with German factories in a particularly steep slump. That boosts any argument for a rapid response by the ECB. Still, some key figures will only come after the July meeting, including second-quarter growth and fresh inflation readings.

While policymakers typically have access to more granular statistics than financial market participants, any extra information on how long the region's manufacturing-led slowdown may last should be helpful in calibrating a response.

The ECB tends to announce major policy shifts when it unveils fresh economic forecasts, as the revised outlook supports the rationale for adding or cutting back on stimulus. The next update is due in September.

The previous round in June foresaw inflation averaging 1.3pc this year and only 1.6pc in 2021, yet that assumed slightly stronger price growth in the second quarter than what ultimately occurred. Revisions of the projections may therefore be under way.

While policymakers say they do not cater to market expectations, it is hard for them to be entirely ignored.

Investors are not fully pricing in a 10 basis point rate cut until September, and an early move could signal the economic situation is worse than perceived. Some ECB officials already classified market participants as too pessimistic at last month's meeting, and may want to avoid painting an overly negative outlook.

Finally, the measures the ECB looks likely to announce will require careful consideration of how to implement them. Most analysts argue a lower deposit rate - which is already at minus 0.4pc - will require a mechanism to exempt some bank deposits from the charge. There are a lot of different ways so-called tiering of reserves could be done. So far, policymakers have not expressed any preferences.

Bloomberg

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