Fresh from Westpac’s Elliot Clarke:
The decision made at the June ECB meeting was broadly as expected. Draghi had all but confirmed a change of tack at the May meeting; and, since that time, leaks from ‘well-placed’ sources provided colour on the likely structure of the policy action.
Not being in a position to fully use its balance sheet at the current juncture, the ECB Governing Council has instead opted for a 10bp reduction in the main refinance rate to 0.15%. Of greater import, June sees the introduction of a negative interest rate for bank excess reserves placed at the ECB (–0.10%). In effect, the ECB is establishing a cost for withholding funds from the economy. With legacy SMP bond holdings of €170bn (no longer sterilised by term deposits) and other deposits at the ECB currently over €100bn, that’s more than a quarter trillion euro that banks will want to find something to do with to avoid the penalty. The rate changes and removal of sterilisation are effective this month.
Seeking to rejuvenate the banking system, the ECB also announced a €400bn targeted long term refinancing operation (TLTRO), whereby funds will be made available to banks to lend to companies and households (excluding mortgages). Note the focus here: household consumption and business investment; not houses or sovereign debt. It bears remembering that this funding is being provided on a repo basis for a fixed term, so credit risk will remain with the individual banks – a key impediment to progress, more on this below. The TLTRO funding will be provided in two parts (September and December 2014), and banks will have until September 2016 to show they have allocated the funds to the real economy. The program will then expire in September 2018.
While almost all the talk ahead of the meeting and at the decision press conference was squarely focused on the decelerating inflationary impulse and the possibility of deflation, this is not what the ECB is (directly) trying to remedy. Rather, disinflation (and indeed deflation in some jurisdictions) is merely a consequence of the slack in the Euro Area economy. The ECB hopes that, action will beget jobs; and with jobs will come more activity (reducing slack in the economy); and with reduced slack will come income and asset growth, and so too inflation. What the ECB and (arguably much of the developed world) are after then is an exogenous spark to economic life.
The logical consequence of lower interest rates for an economy is a lower currency. However, broadly speaking, this has not eventuated for the Euro Area of late. Instead, the Euro has remained elevated, even as alternative easing measures (albeit time-limited variants) were deployed.
It is hard to believe that the June decision will see an abrupt, secular shift in the valuation of the Euro. Indeed, from its current level of around 1.3600, we expect that the Euro will only depreciate to 1.3400 by year-end – a relatively insignificant 1.5% fall. Until such time as the ECB is ready (and able) to commit to a more expansive and active alternative easing approach (read the purchase of financial assets for an unspecified time period), the Euro is likely to trade around the 1.3400/1.3600 range.
As a consequence, it is domestic demand which needs to be fostered by this policy easing. Herein, not only is confidence amongst end borrowers and financial market participants key, but so too is the latter group’s willingness to take credit risk.
Firstly on confidence, available evidence is supportive of strengthening activity. Consumer confidence rose rapidly through 2013, and this trend has continued into 2014. European consumers are happier now than at any time since euro notes and coins were first issued in 2002, except for 2007 – when the GFC and the sovereign debt crisis were not yet dreamed of. Unemployment expectations have also improved markedly.
On the other side of the ledger, firms’ confidence and expectations are mixed: investor confidence is well above average; but German, French and Italian business conditions have plateaued at (only) moderately positive levels. With respect to banks’ willingness to lend, while it is true they have become less concerned over the outlook and have stopped tightening conditions for firms and household alike, they are yet to make a concerted effort to ease conditions. Given the weak state of households’ finances and the elevated level of the Euro, this unease amongst lenders is not that surprising – but it is the exact opposite of what is needed.
To us then, there is hope of stronger momentum in the Euro Area economy as a result of the June ECB decision, but it is far from our base case. The scale of any improvement is likely to be marginal.
Broadly, our expectation for 2014 and 2015 is that domestic demand will begin to support aggregate activity, and that this improvement will be seen across the region. But to say that the region will be set on the ‘path to prosperity’ would be a gross misrepresentation. As is attested by the absence of domestic demand growth and the entrenched downtrend in credit, there is a very real need for a much more concerted approach from the ECB, ideally targeting lending to small and medium sized firms – the job creation machine of all economies.
We continue to believe that this will take place early next year, with the introduction of a program to purchase asset-backed securities and other assets from the banks for an indeterminate period of time. This more active approach would see risk transfer to the ECB’s balance sheet, encouraging more lending. Ideally, it would also push for more immediate capital provision by not providing such a long grace period as the June package has – i.e. allowing banks until late-2016 to show they have complied with the spirit of the policy action.
Arguably, the ECB hopes that by acting now and clearly flagging the next step, banks may pre-empt the ABS program and start writing loans now. But the experience of the other G4 economies where QE type policies have been enacted shows that there is nothing automatic about this.