The ECB’s Surprise Rate Cut

November 7, 2013

In a surprise to private ECB watchers, the Governing Council cut both the refinancing rate and the marginal lending rate to 0.25% and 0.75%, respectively, while leaving its deposit rate at zero.  At today’s press conference, President Draghi denied that the decision was a response to the euro’s external level, asserting that policymakers acted in response to a “significant” change in the inflation outlook both regarding the broadness of goods and services categories experiencing lower inflation and the momentum of the disinflationary process.  Disinflation can be seen in most areas — energy, food and services.  The three-month annualized rate of inflation has dropped.  Until this meeting, officials expected subdued inflation extending into the medium term, with forecasts risks being broadly balanced.  Now, officials concede that the euro area “may experience a prolonged period of low inflation.”  This language intensifies the severity of disinflation with the replacement of the word “subdued” by “low.”  The language also put’s a longer time duration of the forecast of sub-target inflation with the insertion of the word “prolonged.”  A statement released today retains the opinion that inflation expectations remain firmly anchored and consistent with the target of “below but close to 2.0%.”  In the press conference, Draghi said Council members all agreed on a need to respond to the changed outlook for inflation but that differences existed over whether to act initially this month or to wait for more evidence that would be available next month.

In addition to cutting rates, the ECB Council reaffirmed its forward rate guidance, repeating that present interest rates will likely stay at “present or lower levels for an extended period of time.”  And, a pledge was repeated to “consider all available instruments” to enforce such guidance.”  During the conference, Draghi said that a number of options exist and would be utilized before resorting to a negative deposit rate or some type of quantitative stimulus.  The terms governing main refinancing operations and longer-term refinancing operations will continue in place until at least mid-2015. 

Draghi refuted accusations that the bank’s communication of policy had failed.  Money market rates have behaved as intended, and the forward guidance that had led many analysts not to expect a rate cut today had been explicitly conditioned on “expectations of an unchanged overall subdued outlook for inflation.”  This requirement changed during the past month.  A change in the facts caused ECB policymakers to change policy.  This is reminiscent of the Fed’s September decision not to start tapering quantitative easing because actual data trends and downside risks had increased.  Data driven policymaking shouldn’t ever box a central bank into one pre-announced path.  Modification is always possible if the underlying assumptions of forward guidance shift significantly.

In describing Euroland’s economy, Draghi’s statement gives a guarded assessment of the recent exit from recession, noting several positive developments but warning that public and private balance sheet deleveraging will “continue to weigh on economic activity.”  A gradual recovery is the baseline forecast, but it is subject to risks that remain skewed to the downside.  High unemployment, broad-based economic weakness, and subdued monetary dynamics are factors upon which the inflation outlook is based.  In the press conference, Draghi rejected the view that Euroland has stumbled into a similar dynamic that pushed Japan into deflation and then sustained negative inflation for over a decade. 

Although Draghi said the euro played no direct role in today’s action, it’s hard to avoid the conclusion that euro depreciation was likely to happen — and in fact did begin virtually immediately — and offers the speediest dynamic for bolstering growth and countering disinflation.  The eonia overnight interest rate already was lower than 0.1% and can’t drop under zero, the ECB’s continuing bank rate level.  Broad deleveraging at the public and private levels means that the lower refinancing rate will not inspire quicker bank lending.  A weaker euro will lift import prices and support growth in exports and demand for import-competing products.  Given the criticism of the German current account surplus in the U.S. Treasury’s recent semi-annual report, it is totally understandable that Draghi would give absolutely no credence to speculation that a weaker euro was an intended effect of today’s refinancing rate cut.

Copyright 2013, Larry Greenberg.  All rights reserved.  No secondary distribution without express permission.

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