ECB ShadowCouncil on the pros and cons of cutting rates further

Are the latest signs that the worst might be over for the economy of the euro area enough of a reason to end the cycle of easing rates? Monthly pre-meeting discussion of the ECB Shadow Council. Latest and last intervention by: José Alzola

Marie Diron

There is a case for a pause in view of the positive signs both from real economy and financial indicators and of the fact that room for further action is limited. However, economic indicators remain at very low levels and the labour market in particular is likely to continue to deteriorate for a long time. Continued support from monetary policy is therefore needed. The ECB should focus its message on giving insurance that a pause need not mean the end of the monetary cycle and that further stimulus will be provided if needed. Talks that rate hikes could come earlier than generally thought seem much too premature. The ECB?s choice in buying ?60 bn of covered bond was surprising given that the covered bond market is relatively small. However, the liquidity situation has improved and there seems to be no need at the moment to pump more money into the economy.
(Marie Diron is Senior Economist at Oxford Economics in London)

Elga Bartsch

More encouraging green shoots have sprouted across the euro area economy that support the notion of a recovery in the second half. As a result, I believe that it might wise to let the monetary policy measures taken already and those that are still in the pipeline -- such the planned purchases of covered bonds -- to take full effect first. As a consequence, I would be inclined to leave interest rates unchanged for an extended period of time. Only in the event of an unexpected deterioration in the economic outlook and/or a renewed rise in money market tensions, Starting an unsterilized purchase programme with covered bonds in the euro area makes a lot of sense, I think, especially if it is limited to the Jumbo segment backed by mortgages rather than public sector loans. In terms of maturities, I would focus on the three to seven year sector of the market to support longer-dated market funding for euro-area banks. In order to revive the covered bond market, I would also advise to buy in the secondary rather than the primary market. Depending on how the market takes the ECB?s purchases, the programme could potentially be upped or extended to other assets in the future.
(Elga Bartsch is European Chief Economist of Morgan Stanley in London)

Thomas Mayer

Since last month more evidence has emerged that the global reccession is petering out. The odds are in favour of recovery as of the fourth quarter of this year. The euro area will benefit from global economic recovery and from the economic policy stimulus decided in the course of the last nine months. For the first time since the beginning of the crisis we have upgraded our GDP growth forecast (for 2010, by 0.5 percentage points to 0.8%). Against this background, a further cut in interest rates does not appear necessary at present. At the same time, however, I favour an extension of the ECB's covered bond purchase programme to securitised loans. Although it was welcome and well received by the covered bond market, the ECB's announcement of their intention to buy up to EUR60bn of covered bonds suffers in my view view from two short-comings: (1) it is relatively small (especially when compared to similar programmes in the US or UK), and (2) to be successful it requires that banks expand their balance sheets--but that is difficult at a time when they want to reduce leverage. For these reasons it would seem advisable that the ECB offer support to the market for securitised loans (and mortgages) as well as to the market for covered bonds. For a start, the same amount of purchases as planned for the covered bond programme should be envisaged.
(Thomas Mayer is Chief European Economist of Deutsche Bank in London)

Marco Annunziata

While the green shoots are encouraging, I still believe they look so by comparison with the previous two quarters rather than because of their own strength. I have long advocated that rates should be pushed close to zero, and I still believe the underlying weakness of the economy warrants this. I do acknowledge, howqever, that the emphasis has rightly moved to quantitative easing, and that this should be the focus of the meeting. I believe the ECB should clarify the announced decision to purchase covered bonds, and in particular it should make it clear that the purchases will be unsterilized, as there is still need for an overall easing of monetary conditions. It should be made equally clear that the door is left open to possible extension of the quantity and of the kind of assets eligible for purchases. The announced 60bn are a good first step but unlikely to be sufficient if the slump in activity persists, but priority should now go to clarifying the detauils and timiong of the purchases. Overall, the ECB should reiterate that while the green shoots are encouraging, extreme caution is still needed.
(Marco Annunziata is Chief European Economist of Unicredit in London)

Charles Wyplosz

I am in favor of further reducing all rates by 25 bp. Such a move would not make much of a difference, it is mostly for the symbol. The mood has turned and there is much dicussion of the end of negative growth. I think that it is far too early to react for the following reasons: (i) Forecasts are notoriously unreliable these days. (ii) Even if GDPs would stabilize, we have have large output gaps that need to be closed as soon as possible. (iii) We do not know whether European banks are healthy or not as intransparency continues to be the rule of the game. We will need a real-life test: will bank credit resume when the economic situation improve? Until we see this happening, monetary policy must remain where it is today.
(Charles Wyplosz is Professor at the Graduate Institute of International Studies in Geneva)

Jacques Cailloux

The case to lower rates in my view remains, despite signs of improving conditions in financial markets and rising confidence in the business sector. There are two important reasons supporting the case for further easing in my view. First, as long as output is declining or growing below its potential, the case for lowering rates remains. While the ECB is now arguing that current economic weakness has already been taken care of by past rate cuts, I would argue that more should have been done: any simple ECB reaction function or Taylor type rule is pointing to negative nominal rates based on current inflation and GDP forecasts. Rates are simply too high relative to current and expected economic conditions. Second, there is an increasing risk of an exchange rate overshoot if the ECB is perceived to be less accommodative than other central banks. A further strong appreciation of the exchange rate would increase the risks of deflation and add further pressure on euro area exporters. On the purchase of private debt side, let's first congratulate the ECB for having taken the unprecedented decision to actually start buying private assets. As a result of the ECB's announcement, the covered bond market will see a significant improvement even if the initial size of Eur60bn looks small. Indeed, the presence of a new buyer in that market should be sufficient to tighten spreads and increase primary issuance. So for that specific market even a relatively small size might be sufficient to restore confidence. This does not however, resolve the more important issue of credit availability to corporates and households. In my view, the ECB should start buying corporate debt paper as well. Indeed, while corporate bond spreads have tightened and bond issuance has picked up, total net financing to euro area corporates (the sum of net equity, bond and loan issuance) is on a significant downward trend with Q1 seen the smallest net increase in financing since 2004. This trend will deteriorate further in the months ahead given the recent acceleration in the downward trend in credit.
(Jacques Cailloux is Chief European Economist of Royal Bank of Scotland in London)

Erik Nielsen

I fully endorse Marco's comments. In addition, I see particular downside risks stemming from the banking system where a protracted period of negative loan growth is a distinct possibility, and I worry that the next 6 months' negative headline inflation could tranform itself into outrigth deflation. The recent Euro appreciation further increases this concern.
(Erik Nielsen is Chief European Economist of Goldman Sachs in London)

Angel Ubide

My vote is to cut rates to 0.50 percent and make clear that rates will stay low for an extended period of time. Despite some stabilization, the economic outlook remains very grim and uncertain and the European economy clearly needs more policy stimulus. 10yr rates are higher in the EU than in the US despite a gloomier outlook and a better fiscal outlook, thus reflecting the impact of higher policy rates. With headline inflation expected to be zero or negative for several months, and inflation expectations well anchored, there is very little downside in cutting rates at this juncture. Fiscal policy has little or no room for maneuver, and the euro appreciation is tightening financial conditions. Further easing is thus warranted.
(Angel Ubide is Chief Economist of Tudor Investment Corporation in Washington D.C.)

Gaincarlo Corsetti

The most striking fact in the last few weeks is that the slowdown is deeper in Europe than in the US, where we the shock has been supposedly stronger. If the shock was stronger in the US, the difference may come either from structural factors, or from policy. While this may not be the place for a detailed discussion of these two possibilities, and the way they are interrelated, there are many arguments for stressing the latter: Europe is now paying the cost of a comparatively timid stabilization policy, both fiscal and monetary. There is further room for monetary easing which should be exploited. One may argue that maintaining the rate at 1 percent may be the premise to further reaction if things get worse. But this argument could only be sustained, in principle, if the central bank would also commit to a protracted period of loose monetary policy, to make sure that the stance is overall as expansionary as it could be. This is not a feasible solution for the European Central Bank, as it is inconsistent with its strategy it has been building so far. An immediate cut would then be the most reasonable decision, bringing rates more in line with the need of the economy, and counteracting early on the threat of further economic weakening.
(Giancarlo Coressit is Professor at the European University Institute, Rome III)

Agneès Bénassy-Quéré

I think that the ECB should complete the series of interest-rate cuts by a final 25 bp cut. Additionally, the ECB should make clear that it is prepared to (i) buy corporate bonds if the first shot of quantitative easing does deliver enough results, and (ii) intervene on the foreign exchange market if the US dollar was to depreciate markedly. Although the efficiency of sterilized forex interventions is a matter of discussion, unsterilized ones have proved useful in Japan. Failing to react to a large appreciation of the euro when there is a risk of deflation could possibly reinforce detrimental expectations and delay recovery.
(Agneès Bénassy-Quéré is Director of the CEPII research institute in Paris)

José Alzola

The latest data suggest that the recession is abating, both in the Euro area and abroad, implying that downside risks to growth are diminishing. In addition, most of the impact of the stimulative fiscal and monetary policy measures taken in recent months is ahead, so it pays to wait and see how the economy evolves in coming months. At the same time, the inflation outlook remains very favorable. Core inflation has stabilized just above 1% (in annualized terms) in recent months, and the economy will remain sub-par for a few more quarters. As a result, there is scope to maintain the current stimulative monetary policy stance for quite a long time, justifying no bias. The decision last month to purchase around € 60 billion of covered bonds is quite modest and I would have recommended a larger amount and to include other assets. But once it has been announced it should be implemented as it is. A debate about an extension of the amount of purchases of covered bonds or to other assets is undesirable at the moment. Such an expansion should not be excluded in the future, depending on whether the banking system heals rapidly enough.
(José Alzola is senior economist at The Observatory Group)

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