With finger on trigger, European Central Bank aims at more stimulus

Balazs Koranyi and Francesco Canepa, Reuters

Posted at Jul 25 2019 08:30 AM

The euro sign is photographed in front of the former head quarter of the European Central Bank in Frankfurt, Germany. Kai Pfaffenbach, Reuters/File

FRANKFURT -- The European Central Bank is all but certain to ease policy further on Thursday, with the biggest question whether it staggers its moves over several months or opts for a big bang.

With inflation stuck well below its target and the US Federal Reserve already in easing mode, the ECB has flagged more stimulus, hoping to prop up confidence amid a steady flow of bad news that threatens to unravel years of unprecedented support.

It could cut interest rates, perhaps while also helping banks offset the costs to them, restart a recently shuttered bond-buying program or raise the bar for any future tightening of monetary policy.

But with economic data relatively stable there is little urgency to deliver a comprehensive package this week, suggesting the ECB could take its time to prepare the measures and wait for the Fed to set its own course.

This will be crucial for determining the euro's exchange rate against the dollar, presently the single most-watched variable for ECB policymakers.

Having stoked easing expectations already, ECB President Mario Draghi will have to deliver at least something on Thursday. If nothing else, he is likely to unveil revamped interest rate guidance that makes it clear a rate cut is coming and that rates will stay at record lows for much longer than the ECB had previously expected.

"We expect President Draghi to pave the way for further easing and, in particular, to continue fueling quantitative easing expectations," BNP Paribas said in a note.

"However, for now, we think the ECB will only pave the way, but deliver later."

The case for action is supported by weak economic data, particularly in foreign trade and manufacturing, the engine of the euro zone economy's recent growth run.

But some policymakers argue that the outlook has not changed fundamentally from a few months ago, and so the ECB should wait for its staff's new inflation and growth projections in September before calibrating its next move.

Unemployment is still coming down, consumer confidence is stabilising and bank lending growth appears to be holding not far from post-crisis highs, giving the ECB a bit of time.

But with just three months left of his eight-year tenure, Draghi has few more opportunities left to secure his legacy, suggesting big steps will come by September at the latest, before he hands over to Christine Lagarde on Oct. 31.

The ECB announces its rate decision at 1145 GMT (7:45 p.m. in Manila), followed by Draghi's news conference at 1230 GMT.

COMPLICATIONS

The central bank's problem is that any measure it takes comes with complications and will have only limited potency given that the ECB has already exhausted much of its firepower.

"It is not clear that -- at negative rates and a balance sheet as big as 40 percent of the euro zone annual GDP -- another rate cut and further net asset purchases will do much more beyond boosting market valuations," Berenberg economist Florian Hense said.

"But with no major support on the fiscal side and amid very low core inflation, a Draghi-led ECB believes it is worth trying," he added.

Buying more government bonds could also create problems for the bank as it is at or near its self-imposed limits in several of the 19 euro zone countries.

While policymakers say that they have leeway in adjusting their rules, critics of the bank's asset purchases, who have already launched several legal challenges, are almost certain to take the ECB back to court.

A rate cut would also increase pressure on the ECB to shield commercial banks from some of the side-effects of negative interest rates. Lenders transmit the bulk of the ECB's policy and a major financial hit to the sector could render easing measures ineffective.

A proposal for compensation in the form of a multi-tier deposit rate has already come up several times, only to be rejected by policymakers. The negative deposit rate is effectively a charge on banks to park cash securely with the ECB overnight.

"The evidence up until now of an adverse effect on the bank transmission mechanism is not very convincing," ABN Amro said. "The benefits of this system are moderate and it would be difficult to design."

The simplest move would be to redesign the ECB's interest rate guidance, which now indicates that rates will be kept steady through mid-2020.

Policymakers could explicitly point to a rate cut, not just steady rates, and could also drop the date from the guidance, prescribing certain economic conditions for any move.