ECB Interest Rate Decision: Cuts Ahead?

Recent weakness in Eurozone data, low levels of inflation and the uncertainty sparked by troubling circumstances in Italy and Cyprus have prompted an increase in the likelihood of an ECB rate cut this month. Manufacturing PMIs and unemployment data released this week showed a worsening of manufacturing and employment conditions across the currency union. However, most economists expect the ECB to keep rates on hold on Thursday.

Data disappoints

The seasonally adjusted Final Eurozone Manufacturing PMI fell to reach a three-month low of 46.8, down from 47.9 in February, and has now remained below the neutral 50.0 mark since August 2011, according to a Markit Economics survey. “The surveys paint a very disappointing picture across the region, with all countries either seeing sharper rates of decline or – in the cases of Germany and Ireland – sliding back into contraction,” said Chris Williamson, Chief Economist at Markit.

The euro area seasonally-adjusted unemployment rate was 12.0% in February 2013, a notable rise when compared with February 2012, according to Eurostat. The statistical office of the European Union also published flash inflation data on Wednesday; euro area annual inflation is expected to be 1.7% in March 2013, down from 1.8% in February 2013. Food, alcohol and tobacco is expected to have the highest annual rate in March (2.7%, stable compared with February), followed by services, energy and non-energy industrial goods, according to Eurostat.

Arguably, Ifo data released in February was strong enough to mitigate change in monetary policy for now. “The Ifo Business Climate Index for German industry and trade rose significantly by over three points in February. This represents its greatest increase since July 2010,” said Hans-Werner Sinn, President of the Ifo Institute. Although March’s reading edged downwards, the Institute felt the economy remained “on track” and expectations remained “positive”.

Case for cut, but Council not convinced

The likelihood of a rate cut at Thursday’s ECB meeting is the highest it has been for months. However, most economists are expecting the central bank to keep rates on hold in April, as many believe that it will take more time to convince the majority of the Governing Council that a cut is required.

The median probability for a 25 bps rate cut in April is 20%, according to a poll conducted by Reuters between March 25 and 27. A slim majority of economists still see the next ECB rate move as a 25 bps increase, however, a large proportion – 15 of 48 – expect a rate cut in Q2 2013 (6 expect a cut in Q3 2013, 16 expect a move in 2014 and the remaining 11 expect a change in 2015).

There is certainly more room for easing. The OECD recently said the ECB should consider giving more forward guidance and look at quantitative easing in an effort to revive Eurozone growth. “There is space for more traditional monetary policy because the rate can be lowered,” OECD Chief Economist Pier Carlo Padoan said in an interview. “We see no inflation risks coming up and we see the need to use monetary policy to support the economy.”

Economist opinion

A benign inflation outlook and continued weakness of economic activity create a strong prima facie case for further monetary easing in the Eurozone, according to the Economics Research Team at Goldman Sachs. “We continue to expect the ECB to keep its key policy rates on hold at the April Governing Council meeting next week,” they add. The ECB has established a very easy monetary policy stance in the Eurozone, but, owing to impairments to monetary policy transmission, this easy policy stance is not being passed through to the real economy in the periphery. In the eyes of the ECB, cutting policy rates in this context is a largely futile exercise.

Peterson Institute for International Economics’ (PIIE) senior economist said the threshold for additional rate cuts is “extremely high.” “Zero growth ... is not going to be enough” to cause the ECB to act, and “they aren’t going to do something major unless they are asked to do so by governments,” said Senior Fellow Jacob Funk Kirkegaard, presenting at PIIE’s semi-annual economic outlook. “The ECB will remain on the sideline,” and “Monetary policy will remain very reactionary.”

“If the data is bad enough over the next month, this could trigger a response, or at least flagging the risks for June”, wrote TD Securities analyst Richard Kelly, expecting a refi rate cut and narrowing of the corridor as the likely move in such scenario. “While it would provide limited stimulus to the economy … the rate cut would cheapen funding for banks that still have outstanding LTROs and would hope to improve sentiment”, he continued.

In the view of Strategists G. Yu and M. Narain at UBS, “We expect the ECB to keep its monetary policy accommodative, with rates on hold. We do not think that the economic outlook is so weak that it would warrant further ECB rate cuts in 2013 and 2014”.

Brown Brothers Harriman analysts are expecting the ECB to make a rate cut, most likely in Q2. They write, “We expect the ECB to leave the door open for a cut in its next meeting, but that it will not panic into a move.” They feel that current weakness of the Eurozone economy is not unexpected, so the bar for a rate cut is high. However, if, as expected, the weakness is more prolonged, they feel that could lead to a cut. In addition, they add that it might not be growth per se, but the risks of deflation that drives the decision.

No contagion risk

The Cyprus issue is likely to be raised in ECB President Mario Draghi’s press conference. The concerns about uninsured deposit flows following the Cyprus bailout have led to questions about the potential disruption to the transmission mechanism. Some have argued that this could lead to the introduction of non-standard measures; however, it is more likely that Draghi will state that the Bank is ready to take action if the liquidity situation in the Eurozone deteriorates – one week’s increase in Emergency Liquidity Assistance (ELA) will not be enough to push the ECB to action. At the very least, Draghi will try to calm the markets by reassuring investors that there is no contagion risk, as ECB governing council member Nowotny recently asserted.

The President may also be asked about Slovenia, regarded by many as the next crisis brewing. The Slovenian central bank Head, Kranjec, has denied the country needs a bailout in the last few days and weeks.

Help for SMEs?

SMEs are struggling to expand in the Eurozone’s most indebted states due to high financing costs. Some have suggested that a change in collateral rules for loans would greatly assist SMEs, enabling them to better help drive economic growth needed to bring down national debts.

On March 14, ECB governing council member Liikanen said the central bank is discussing how to cut funding costs for SMEs in countries most affected by the debt crisis. “This is a difficult question but I can say it is on our table, under consideration,” Liikanen told a news conference.

Another member of the governing council, Cypriot central bank chief Demetriades, also hinted that the ECB could take further action to help SMEs in an interview with Reuters. “I don’t think we should rule out the possibility that there might be non-standard measures that may help particular sectors of the economy more than others,” said Demetriades, when asked about SME funding difficulties.

President Draghi, however, played down any help for SMEs at the March meeting, including potential changes to collateral rules.