The ECB did not surprise markets this week. As widely expected the Bank cut the refi rate by 25bp, leaving the interest rate on deposit facility at 0%. Yet, the ECB left the door open for further actions on interest rates, should conditions deteriorate.



  • The ECB did not surprise markets this week. As widely expected it cut the refi rate by 25bp to 0.50% a new low, keeping the interest rate on deposit facility (DFR) at 0%. The corridor was reduced to +/- 50bp. Yet, the poor state of the economy probably would have justified a bolder action, with a cut of at least by 50 bp 

  • Recently released data confirm that the eurozone patient remains sick. Not only activity kept contracting in the first quarter of the year, but early survey data for the second quarter showed that confidence continued to deteriorate. Levels of leading indicators are quite low by historical standards, suggesting that a return to growth in the shortrun is unlikely. More alarmingly, Germany, the main engine of the eurozone, is running out of steam. Contracting activity in peripheral countries combined with sluggish growth in core countries jeopardise the ECB’s view that the eurozone might return to growth in the second half of the year. 

  • As regards to prices, the ECB risks overshooting its target. Inflation is well below the 2% ceiling target. In April, it fell to 1.2%, from 1.7% in March and 2% at the beginning of the year. Methodological changes concerning how to treat some items of the HICP basket might have added some volatility as did the sharp decline in energy prices, the slack of the economy is clearly biting. Inflation might partially rebound going forwards. Yet, it is on a downward trend. According to its latest projections (released in early March), the ECB forecasts inflation at 1.3% in 2014. Downside risks to this scenario have probably increased. 

  • Against this backdrop, the ECB opted for a 25bp refi cut. Yet, the Council did not close the door to further cuts. First of all, while the prevailing view in the Council was for a cut of 25bp, the discussion went also on cutting by a larger amount. In addition, President Draghi re-affirmed that “the ECB was ready to act”, a sentence which suggests that 0.50% probably is not the lower bound for the refi rate. 

  • A refi rate cut will clearly help all those banks which still heavily rely on the ECB liquidity, mainly banks from peripheral countries. By contrast, the impact on the yield curve will be lower, as the DFR, which under the current refinancing framework of “full allotment-fixed rate” has become the key policy rate signalling the ECB monetary policy stance, was left unchanged. 

  • Will this cut be able to reactive credit? As stressed above, banks, particularly in countries where credit is contracting the most, will benefit from easing funding conditions. On this front, the ECB went further ahead, committing itself to maintain the current structure of full allotment fixed rate for all its refinancing operations at least until the end of Q2 2014. In this way, the ECB wants to solve liquidity problems for banks. The ECB is working as well on new initiatives concerning ABS collateralised by loans to non-financial corporations and how to intervene in this market to stimulate credit growth. 

  • Yet, lack of demand for credit and default risk of counterparts play a non-negligible role behind the poor lending statistics. Not surprisingly, the stock of non-performing loans (NPLs) is highly correlated with economic variables. The more distressed an economy is, the larger the amount of NPLs is. The ECB still has additional ammunitions to stimulate demand. It could cut further the refi rate and commits, as done by other central banks, to keep the refi rate unchanged for a while (forward-guidance). This move would reduce interest rate expectations as well as the external value of the euro, eventually stimulating growth. 

  • The ECB could also put into negative territory the DFR, which, as explained above, has a larger impact on market rates. Mr Draghi said that the Bank is “technically ready” to do it. The advantages of negative DFR stem from lower market rates (the Eonia could be negative) and a lower exchange rate. There are, however, disadvantages as well, mainly related to further costs for the banking sector and a potential reduction of excess of liquidity in the money market, which might tighten financial conditions. For the time being the disadvantages overcome benefits in the ECB’s balance of weights; yet things might change over the coming months.