Mario Draghi must decide whether it’s time to use up one of his remaining interest-rate cuts.
Inflation in the euro area has slowed to less than half the European Central Bank’s target and unemployment is the highest since the currency bloc was founded in 1999. While that boosts the case for action to shore up the region’s recovery, the ECB President has only two quarter-point reductions left before reaching zero. That’s a constriction that may give him pause, reflected in the fact that just three of 70 economists surveyed by Bloomberg News expect a cut in the benchmark rate today.
As the ECB runs out of conventional tools, it risks being pushed toward uncharted territory such as quantitative easing, which may exceed its mandate, or a negative deposit rate that might have unintended consequences. Policy makers meeting in Frankfurt may prefer to postpone the choice by waiting out what could prove to be a temporary lull in the price level.
“By not reaching the zero lower bound, Draghi can avoid the really difficult question of what do they do next,” said Marchel Alexandrovich, a senior European economist at Jefferies International Ltd. in London who predicts the ECB will stay on hold for now. The ECB “can comfortably sit on its hands and choose to act only if the recovery stalls,” he said.
‘Hard to Resist’
The central bank will announce its interest-rate decision at 1:45 p.m. in Frankfurt and Draghi will hold a press conference 45 minutes later. The Bank of England kept its benchmark rate at a record-low 0.5 percent in London today, while its bond-purchase plan stayed at 375 billion pounds ($603 billion).
Inflation in the 17-nation euro area fell to 0.7 percent in October, the slowest in almost four years. The ECB aims to keep price gains close to and under 2 percent over the medium term. When inflation slumped to 1.2 percent in April, Draghi cut rates a month later to a record low of 0.5 percent.
“There comes a point where inflation is so weak, and coming in weaker than anticipated, that the case for loosening policy becomes too hard to resist,” said Richard Barwell, senior European economist at Royal Bank of Scotland Group Plc in London and one of the three forecasters to predict a cut today. “We believe that the Governing Council will have reached their pain threshold on low inflation in the November policy meeting.”
After exiting its longest-ever recession in the second quarter, the euro-region’s economy is showing signs of fragility. Unemployment is at a record 12.2 percent and the currency has climbed almost 5 percent against its major peers this year, curbing the competitiveness of exporters and depressing prices.
Some of the economists who predicted rates will stay on hold today said the ECB will wait for more data including its staff forecasts for growth and inflation, which are scheduled for publication in December. Under Draghi’s predecessor, Jean-Claude Trichet, those traditionally provided the justification for a shift in interest rates.
We “expect President Draghi to note the temporary nature of the downside surprise in the October inflation,” said Laurent Fransolet, head of European rates strategy at Barclays Plc in London. “The ECB would prefer to wait for November inflation data to get a clearer picture on price developments and to elaborate on its new inflation outlook.”
Draghi has on occasion declined to wait for the new outlook. In November 2011 he cut rates at his first meeting as head of the central bank. In July, he promised to ensure rates remain at the present level or lower for an extended period.
The current euro-area inflation rate “is clearly not in line with the monetary-policy target of the European Central Bank,” the European Union’s Economic and Monetary Affairs Commissioner Olli Rehn said on Nov. 5. “I trust that the ECB, in line with the forward guidance provided by President Mario Draghi, will take this into account in its monetary-policy decisions.”
Draghi may not heed him. The ECB has forecast for nearly a year that it expects inflation in 2014 to be less than 1.4 percent, well below its target, without signaling that this in itself is enough to trigger a rate cut.
“The latest inflation numbers are shockingly low but I don’t think Draghi will act on it as of now,” said Kristian Toedtmann, senior economist at Dekabank in Frankfurt. “The most important indicator for the ECB is inflation expectations rather than current data.”
Draghi has consistently said that he has multiple policy tools at his disposal, including providing more liquidity to euro-area financial markets. A technical committee tasked with considering liquidity options met for two weeks last month.
New measures could include longer-term refinancing operations with fixed or floating rates, different maturities or rules on how banks must use the cash. Other possible measures include changes to reserve or collateral requirements, the suspension of liquidity-absorbing operations, or the extension of full-allotment loans.
Governing Council members have played down the urgency of new liquidity measures as market interest rates have declined. The overnight rate banks expect to pay for loans by the October 2014 ECB meeting was at 0.18 percent today, down from 0.33 percent in June.
A Fed-style quantitative easing program has repeatedly been ruled out by ECB policy makers. The central bank is barred by European Union treaties from financing state debt, making large-scale purchases of government bonds open to a legal challenge.
While Draghi has floated the prospect of a negative deposit rate, the rate for commercial lenders who park excess cash at the central bank, policy makers have said that its effects can’t be adequately predicted.
A negative deposit rate could hurt banks’ profitability by lowering money-market rates, potentially hampering credit supply to companies and households and reducing banks’ incentive to lend to other financial institutions.
The pressure on the ECB to act to counter a strengthening euro has eased. The single currency has dropped against the dollar since the Oct. 31 inflation report. The euro was at $1.351 today, down from a two-year high of $1.3832 on Oct. 25. That leaves the duration of the slump in inflation as the key indicator for the next ECB policy move.
“The low-inflation theme has put pressure on the ECB to ‘do something’ about it,” said Frederik Ducrozet, senior euro-area economist at Credit Agricole CIB in Paris. “The ECB is likely to wait for the updated staff forecasts before it makes a decision. The case for a rate cut is not compelling.”