At the ECB meeting last month, Mario Draghi described two scenarios that would lead to action. We saw both of these triggers materialise in January. Therefore, we expect the ECB to ease again on Thursday.
The euro inflation declined again in January, and it is now almost certain that inflation in Q1 will be below the ECB's December staff projection. This negative surprise combined with declining inflation expectations means the pressure on the ECB to ease further is high.
The higher money market rates seen in January are a second concern for the ECB. In the absence of a policy response and with excess liquidity at the current level, we believe it is likely the volatility in the money market will persist.
Moreover, the case for further ECB action has been strengthened by the data for monetary development, which showed a further weakness in December. Bank lending remains alarmingly weak and signs of a turn for the better are fragile.
The most likely response is a refi rate cut to 0.1%, while keeping the deposit rate unchanged at 0%. The Governing Council may also consider stopping the sterilisation of SMP purchases, which would increase the liquidity surplus by almost EUR180bn.
Even though the EONIA market is pricing some probability of further easing from the ECB, we would expect a refi rate cut to result in a decline in money-market rates. Moreover, we see good potential for a move lower in EUR/USD.
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