Draghi’s Rate Tonic Seen Piquing Taste for Stronger Stuff

ECB President Mario Draghi
Mario Draghi, president of the European Central Bank. Photographer: Ralph Orlowski/Bloomberg

Mario Draghi’s experiment with negative interest rates is unlikely to stop investors from seeking something stronger.

The European Central Bank president will herald a new era today by taking the deposit rate below zero, according to economists in a Bloomberg News survey. That probably won’t quell calls for more radical measures such as quantitative easing to stop the euro area from sliding into deflation.

Draghi has said broad-based asset purchases would be justified by a worsening in the medium-term outlook for prices, and with inflation stuck well below the ECB’s goal for the past eight months that’s a scenario that remains possible. While he’s unlikely to announce a QE program today, he may keep the option alive by providing insight into how a plan could overcome the practical challenges it faces in an 18-nation currency union.

The tipping point at which QE is needed “is getting awfully close and we expect the ECB to make clear that QE will be deployed next in case of any further deterioration in inflation expectations,” said Thomas Harjes, an economist at Barclays Plc in Frankfurt. “Markets clearly do not see inflation rising back to target over the policy-relevant horizon.”

The rate on 2-year euro inflation-linked interest-rate swaps, 2-year forwards has traded between 1.2 percent and 1.4 percent since March, according to Barclays. The ECB’s goal is to keep inflation at just under 2 percent.

Rate Pledge

In the Bloomberg survey, 44 of 50 economists said the ECB will cut its deposit rate to negative from zero, with the median estimate for a level of minus 0.1 percent. The survey also predicts that the benchmark rate will be reduced by 15 basis points to a record-low 0.1 percent.

The decision will be announced at 1:45 p.m. in Frankfurt. Draghi will hold a press conference 45 minutes later, where he’ll also release revised ECB forecasts on inflation and economic growth.

Should rates be cut, Draghi will probably signal that his room for maneuver isn’t over by reiterating his pledge to keep borrowing costs at “present or lower levels,” two euro-area central bank officials said this week, declining to be identified because the discussions aren’t public.

The briefing may also be the venue for him to announce non-standard measures aimed at stimulating lending to the real economy, which ECB data shows has been falling for two years and has only in recent months started to show tentative signs of stabilizing.

Conditional Liquidity

A program modeled on the Bank of England’s Funding for Lending Scheme is one option, and banks may be offered funding equivalent to 5 percent of their outstanding loan portfolios, one of the people said.

Speculation that the ECB will act has pushed the euro down 1.7 percent against the dollar since the last policy meeting on May 8. Officials have cited a strong currency as one factor curbing inflation by reducing the price of imported goods. The euro was little changed at $1.3606 at 8:48 a.m. Frankfurt time.

Even so, markets are already braced for all those measures, according to Holger Schmieding, chief economist at Berenberg Bank in London.

“It would probably take a major surprise to get a big and lasting market response beyond any initial knee-jerk reaction,” he said. “Serious quantitative easing could be such a surprise, boosting equities and bonds and weakening the euro by a few cents for a while. We consider such QE highly unlikely.”

‘Negative Spiral’

The ECB views QE, or large-scale asset purchases with the aim of boosting the money supply and thereby inflation, as a legitimate option. At the same time, it isn’t an easy one, as the euro area lacks a unified government debt market that would be the obvious target for purchases, making the appropriate assets for an effective QE policy hard to select.

Government bond yields are also already at record lows, yet that isn’t feeding into bank lending for small and medium-sized firms. Draghi has been promoting a functioning market for asset-backed securities to improve the flow of credit to SMEs, which account for 80 percent of employment in the euro region. That market has withered since the financial crisis.

The BOE will probably keep its own bond-purchase plan at 375 billion pounds ($628 billion) and hold its benchmark rate at 0.5 percent when it announces its policy decision at 12 p.m. in London today, according to separate Bloomberg surveys. The U.S. Federal Reserve is tapering its asset purchases as officials debate an exit from its ultra-loose monetary policy.

‘QE Firebreak’

Draghi hasn’t yet conceded that the threshold for QE in the euro area has been reached, though he has stepped up his warning that the trigger may be near.

“What we need to be particularly watchful for at the moment is, in my view, the potential for a negative spiral to take hold between low inflation, falling inflation expectations and credit, in particular in stressed countries,” he said last month at the ECB Forum in Sintra, Portugal.

Inflation in the euro area slowed to 0.5 percent in May, matching the lowest in more than four years. Officials will significantly reduce their 2014 inflation outlook from the 1 percent forecast in March when they publish their latest forecasts today, one of the central-bank officials said.

Market expectations are focused on a remedy for that issue, and less on liquidity or bank-lending difficulties, according to Richard Barwell, senior European economist at Royal Bank of Scotland Group Plc in London.

“My working assumption is that what they want to do is announce a lot of things to impress us all and that will act as a QE firebreak,” he said. “But what I think will happen is that it won’t act as a QE firebreak, it will act as a QE accelerator. The market will say: All you have to do now is buy assets.”