Friday, November 8, 2013

Surprise rate cut from the ECB

While it could be argued that the recent decline in Euro zone inflation and downward revision to Euro zone growth forecasts by the European Commission means last night’s rate cut by the ECB was not a surprise, the bigger surprise would be if they think it will make any difference.

The ECB cut its main refinancing rate 25bps to 0.25% and its marginal lending facility 25 bps to 0.75% while keeping the deposit rate unchanged at 0.0%.  The ECB maintained its easing bias indicating that interest rates are likely to remain “at present or lower levels for an extended period of time”.

Recent inflation data has spooked the ECB.  Headline inflation dropped to +0.7% yoy in October with core coming in at +0.8% yoy meaning that deflation is the greater immediate risk than inflation.  While ECB President Mario Draghi stressed that he does not expect deflation, at least not in the true sense of the word, the ECB does now expect a “prolonged period of low inflation”.

The fundamental problem is low growth and the yawning chasm that is otherwise known as the output gap, best indicated by the current Euro zone unemployment rate of 12.2%.  While we were confident of an end to the Euro zone recession in 2013, we have remained cautious about the extent of the pick-up in growth.  Indeed the European Commission this week revised their 2014 Euro zone growth projections down, albeit only a tad from 1.2% to 1.1%.  We think they are still too optimistic – we are happy with our forecast of +0.8% for next year. 

Euro zone growth is constrained by ongoing austerity at the sovereign level, deleveraging at both the corporate and household level, and weak domestic demand on the back of the high unemployment rate.   The issue for the ECB is the transmission mechanism of its actions through to growth and ultimately inflation.  Market interest rates are already lower than the policy rate making ECB rate cuts largely symbolic. I’d prefer to see something more targeted such as credit expansion aimed at the SME sector, the primary source of job creation in most developed economies.