European policymakers meet in Vilnius on Thursday as concern mounts over the health of the eurozone’s economy.
A sharp slowdown in inflation this week fuelled investors’ doubts about the European Central Bank’s ability to hit its target of below but close to 2 per cent.
This forms a “challenging backdrop” to its latest meeting, according to Marchel Alexandrovich, senior European economist at Jefferies.
Markets’ expectations are growing that the guardians of the single currency will have to confront the question of whether to launch a further round of monetary stimulus. ABN Amro’s Nick Kounis predicts that the bank will have to restart the expansion of its €2.6tn quantitative easing programme.
“We judge that the ECB will react to a more prolonged economic slowdown by relaunching QE,” Mr Kounis said, in response to the latest fall in inflation.
He forecasts that the central bank will make the announcement by the end of this year, “with actual purchases starting in January 2020, though it could be launched early”. ABN Amro estimates the ECB will opt for nine months of purchases at €70bn a month, leading to a total size of €630bn.
While many would still bet against Mr Kounis, ECB president Mario Draghi is expected at a minimum to signal that the bank stands ready to act, should inflation continue to underwhelm.
“With inflation and inflation expectations both uncomfortably low, and the US Fed making the ECB’s job harder by dithering over the direction of policy, the markets are increasingly looking for the ECB to deliver more than just words and set out a road map of how it may respond,” Mr Alexandrovich said.
The ECB has a new chief economist, former Central Bank of Ireland governor Philip Lane. It will fall on Mr Lane’s shoulders to present the bank’s latest forecasts for inflation and growth.
The previous round of projections, in March, showed growth rising 1.1 per cent this year, 1.6 per cent in 2020 and 1.5 per cent in 2021. Inflation is set to hit 1.2 per cent this year, 1.5 per cent in 2020 and 1.6 per cent the following year.
No big downgrades are likely this time around. However, the fall in inflation expectations and the intensification of the global trade war are likely to lead Mr Lane to emphasise that the risks to the economy are tilted to the downside.
Shaking inflation expectations
Rates will almost certainly remain on hold, with the main refinancing rate staying at zero and the deposit rate at minus 0.4 per cent. What could come up for debate is whether to extend the ECB’s message on how long it intends to keep its monetary stimulus in place.
At the moment the council expects rates to remain at their present levels until at least the end of this year and it will continue to reinvest the proceeds of maturing securities bought under QE for an extended period after that.
But few investors expect the central bank to raise rates until the end of 2020 at the earliest – leaving a gulf between the ECB and the markets.
“Something has to be done about inflation expectations, which have plummeted to near all-time lows,” said Erik Nielsen, chief economist at UniCredit. “If I were in their shoes, I would now try to shock the market back to believing in their ability to get inflation back toward 2 per cent.”
How cheap will the ECB’s cash be?
The governing council is expected to publish further details of its forthcoming programme of cheap loans for eurozone banks, dubbed TLTRO III. The auctions begin in September.
Policymakers want the loans to act as a backstop for weaker banks. When the plan was unveiled in March, the assumption was that the loan terms would be a lot less generous than in previous lending rounds. But recent news on inflation – plus disappointing business surveys – could force a rethink.
Tinkering with negative rates
The council is also discussing whether its negative rates policy hinders banks’ ability to lend by cutting into their profits.
The ECB charges 0.4 per cent on a portion of banks’ reserves which are parked at central banks across the 19 member states.
According to research by Deposit Solutions, a banking platform, the policy has cost banks €21.4bn since it was first introduced. The cost is unevenly split among member states, with banks in Germany, France and the Netherlands accounting for 70 per cent of the charges between 2016 and 2018.
The ECB could lower the cost by moving to a system similar to those in Switzerland or Japan, where a larger level of reserves are exempt from the charge.
When Mr Draghi first mentioned the idea earlier this year, investors assumed it would be introduced – either as a means of bolstering the ECB’s message that interest rates will remain on hold for some time yet, or to leave space for further rate cuts in the future. But many on the governing council are not convinced that negative rates are hindering banks’ profitability that much.
So any indication of a move to amend the negative rates policy would be a boon for eurozone banks.