The ECB is ready to do more

Market analysis - 2/29/2016

Economic growth is firming up in the eurozone. Based on our econometric models, we expect full-year GDP growth of +1.8% in 2016, versus +1.5% recorded in 2015 and +0.9% in 2014 (see left-hand chart).

In 2017, growth is likely to ease, but not drop significantly. It simply cannot remain above its long-term growth potential of 1.2% for very long.


If the eurozone is doing so well, why is the European Central Bank (ECB), under Mario Draghi’s leadership, planning to ease monetary policy on 10 March? There are four main reasons at play.

The first – and least honourable – reason is that economic actors are addicted to highly accommodative monetary policy, including the ECB's. By printing reams of money, central banks are able to bring down the cost of credit and support the property, bond and stock markets by allowing liquidity bubbles to emerge.

The second reason, much more rational, stems from the fact that quantitative easing is only effective if it is left in place long enough to allow for a structural recovery in demand. The US Fed’s programme, for example, lasted six years. The eurozone’s, on the other hand, has been in place for just over a year (see left-hand chart).



The third reason has to do with the ongoing risk of deflation. Prices have not risen in more than two years (see right-hand chart on the previous page), and the euro’s brief rally made imports even less expensive. Mario Draghi and the ECB governors are absolutely intent on keeping deflation at bay. The International Monetary Fund uses the word lowflation to refer to nearly stagnating prices. It is an uneasy situation in which inflation is positive but very low for several years and inflation expectations can deviate
from official targets. This is now the case in the eurozone (see right-hand chart).

The fourth reason: in the medium term, the ECB will have to adjust in response to the Fed’s actions. A decision by US monetary authorities to raise their key rate this year could push up bond yields worldwide. While this may seem impossible at this point, it cannot be ruled out completely. To offset upward pressure on the eurozone yield curve, the ECB would have to deliver a clear message that it is prepared to buy more euro-denominated bonds and for a longer time.

For all these reasons, the ECB will further relax its monetary policy on 10 March. The governors just need to agree on how far to bring deposit rates into negative territory and how far they will go in lowering the quality of paper they will accept as collateral. They will also have to decide how they will take quantitative easing one step further: by extending the time period or by expanding the monthly asset purchases. Putting in place an 'unlimited' asset purchase programme – like the Fed did in 2012 – whose end date would depend on a defined goal – such as inflation above 2% – would be a very aggressive and effective approach. And investors would be delighted. We will keep a close eye on this. This scenario would provide the visibility needed for economic activity to pick up steam and unemployment to decline even further (see the 18 January 2016 issue of Macro Highlights & Strategy).

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