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ECB Shadow Council discusses the scope for going below one percent and need for outright quantitative easing

The other G10 central banks have slashed their key rates to 0.5 percent and below. The ECB seems to want to stop at 1 percent. For good reasons? Latest post by: Stephen King

Julian Callow

In recent weeks the financial markets have smelt recovery. For example, the eurostoxx index is up about 18% during the past six weeks, while the Euribor-OIS spreads have fallen below 60bp, to their lowest since March 2008. The battery of measures adopted by G20 central banks and governments appear to be bearing fruit. Our estimates suggest that euro area banks have been lowering their lending rates to companies and to households roughly in line with the reduction in Euribor, suggesting that the money transmission channel continues to function.While we often focus on the change in interest rates, the level is also very important, and I believe that the cumulative impact of such low interest rates will be substantial. That said, we are dealing with a terrible rise in unemployment. The euro area unemployment rate has risen from a low of 7.2% in Q1 08 to 8.5% in February, and is likely to be 8.7% in March. With the widespread use of government support for short-time working, and with the extremity of the downturn, it is likely that unemployment will continue to surge during the next year - to a post-war high of 11.0% by end-2008.

Overall, I continue to have reservations concerning recommending a shift to "full-bloodied" quantitative easing - ie. a policy of printing money outright, particularly since the euro is still such a young currency, and partly because I am not persuaded so far that the benefits of such an approach outweigh the disadvantages. However, I do think it would be appropraite for the ECB to utilise its remaining leeway: to lower the deposit rate to zero and to cut the main refinancing rate to 0.75% (i.e a 50bp cut). The ECB has hinted at an extension of the maturity of its longer term refinancing operations to include twelve month maturities. This would be a welcome move
Julian Callow is Chief European Economist of Barclays Capital in London.

Marco Annunziata

While the deposit rate has been an effective instrument to push down market interest rates, I would still favor a transparent strategy of pushing the Refi close to zero to signal a clear determination to fight the risk of a deflation/prolonged recession scenario, which I still think is the dominant risk. The growth outlook is still deteriorating, albeit at a slower pace, and we probably face a rapid further tightening of credit conditions. The growth prospects in the Eurozone are, if anything, worse than in several other developed regions, and I think the ECB should not delay any further the adoption of full-fledged traditional quantitative easing. The ECB should therefore announce a program of purchases of bank bonds and corporate bonds. This would have the benefit of helping meet the banks’ medium-term funding needs and to channel credit directly to the real economy. I realize that the relatively small size of the Eurozone corporate bond market and its uneven distribution across countries make purchases of private bonds a blunt and imperfect instrument. However, it would still provide precious support to an embattled real economy. In short, I see no plausible reason for the ECB not to follow the more aggressive course of action of other major central banks.
Marco Annunziata is Chief European Economist of Unicredit in London

Thomas Mayer

The speed at which the economy contracts seems to have slowed a little in Q2, but a bottom of the downturn is not in sight. As companies and private households feel the financial stress of the downturn, write-offs on bank loans will rise. With bank loans being the main vehicle of financing in the euro area and loans being marked down much slower than capital market securities, euro area banks are likely to feel the full effect of the downturn this year. As a result, there is a serious risk that the credit crunch in the euro area will intensify this year while it may ease elsewhere, where significant write offs on banks' securities portfolios have already occurred and authorities have been more proactive in supporting credit markets. Against this background, I believe that a further 50bp refi rate cut is warranted and that the ECB should launch a purchase programme for new securitised bank loans to help maintain the flow of credit to the private non-financial sector.

Regarding rate cuts, it has been argued that 1% should mark the lower limit of the refi rate in order to keep the interbank money market alive. While the interbank money market clearly helps to distribute central bank money through the banking system I believe that at this stage a further 50bp cut of the refi rate (and a narrowing of the spread to the desposit and marginal lending rates to 50bp) would have a more favourable effect on credit creation by the banking sector than a smaller step signaling the end of the rate cut cycle. We should of course monitor developments closely thereafter to see when the disadantages of further rate cuts outweigh the advantages.

Regarding non-traditional measures, I think the ECB should support credit flows to non-banks by offering banks to purchase from them newly securitised loans. This would allow banks to reduce their balance sheets while they write off non-performing loans without closing down new lending. Past experience suggests that an annual increase of outstanding credit of about 6% is in line with growth around potential. Hence, an ECB programme for the purchase of newly securitised loans of 6% of outstanding credit on a one year horizon would seem to have about the right size. This would put the programme at about 7% of M3 and GDP. By comparison, the UK programme is equivalent to 10% of GDP and 7.5% of broad money.
Thomas Mayer is Chief European Economist of Deutsche Bank in London

Elga Bartsch

My vote is in favour of a 50 bp rate cut in the refi rate and a signal that interest rates will remain at this level for an extended period of time. A signal for the end of the interest rate easing cycle is key to ensure that the longer-dated refinancing operations that I would also like to see the ECB announcing at the May meeting will actually be taken up by the European banking sector. Cutting the refi rate to 0.75%, would push the deposit rate to 0%, which I don’t see to create particular problems as the EONIA overnight rate seems unlikely to follow suit. In order to keep the corridor symmetrical, the marginal lending rate needs to be cut by 75 bp. Another large interest rate cut would take on board the recent further deterioration of activity during the first quarter and – notwithstanding a number of tentative signs of improvement in various sentiment indicators – the absence of any statistically significant signals for a turning point in the business cycle.
Elga Bartsch is Chief European Economist of Morgan Stanley in London

Marie Diron

Although recent economic news has been relatively positive, the most likely scenario remains one in which things get worse before they get better. It is as yet unclear to which extent the rise in business surveys merely reflects the end or even only a slower pace of destocking. The euro area economy is forecast to perform worse this year than most other developed economies with negative consequences for companies' pricing power and hence inflation. In this view, a further 50bp cut in interest rates to 0.75% is warranted, accompanied by quantitative easing such as purchases of corporate bonds. Barring rate cuts below 1% and sounding timid and divided about quantitative easing would send a signal that monetary policy means have been used up.
Marie Diron is senior economist at Oxford Economics in London

Jörg Krämer

Why should the ECB lower the refi rate to below 1.0%? A refi rate of 1.0% anyway suggests an extremely expansionary monetary policy, especially when one takes into account that the ECB provides unlimited liquidity to the banks. Lowering the rate to below 1.0% would cause diffculties insofar as the spread between the refi rate and the deposit rate (currently 0.25%) would shrink too much. This would make it less costly for banks to park the liquidity with the ECB. I am not in favour of lowering the refi rate to below 1.0%

In addition, ,the ECB should raise the maximum maturity of its longer-term refinancing operations from 6 to 12 months. This helps to lower money market rates also for longer maturities. With this decision the ECB would start to move closer to those central banks which already committed to keep rates at the current low level for a prolonged periode. The ECB should outright purchase bonds only if there is a significant risk of a credit crunch. Currently, the bulk of the slowdown in lending growth can empirically easily be explained by less demand for credit and not by tighter lending standards.
Jörg Krämer is Chief Economist of Commerzbank in Frankfurt

Angel Ubide

I am in favor of a rate cut by 50bps and of making a statement that the refinancing rate will remain at this level or lower for a long period of time, reinforced by an extension of the maturity of the repo operations. I would like the deposit facility at 0.25, and thus shrink the corridor to 50bps. In fact, I would have no problem cutting rates to 0.50 percent, which would probably be my lower limit, and I don;t rule voting for it next month or even changing my mind at this meeting. The economic outlook in the rest of the world is showing some signs of stabilization, but I am less sure about the euro area. There is a worrisome increase in unemployment is some countries that could easily become a long term problem, and policies should be very aggressive now to take advantage of the incipient recovery in confidence and push it upwards. Policy making in this environment is about managing risk aversion as much as about managing financial conditions, and the recent timid and confusing actions of the ECB have been very ineffective in lowering risk aversion. This is a time for clear and bold actions, and thus it is time to abandon the divergence between the policy rate and the market rate, which only creates confusion.

As far as non conventional measures, I think the ECB should finally admit that some markets are no longer working and will require support. The concept of not replacing markets is no longer appropriate, as it is clear now that some markets may never return without public support. Thus a program of purchases of new securitized assets would be warranted, as it would help kickstart that market. I am less convinced about the need to buy government bonds or even plain vanilla corporate bonds. In any event, if the ECB were to engage in any purchase, it first must obtain from the Finance ministries a clear understanding that any loses will be absorbed by the fiscal authorities.
Angel Ubide is Chief Economist of Tudor Investment Corporation in Washington

Erik Nielsen

Given the the outlook, taken all the recent "green shoots" into consideration, a simply forward looking Taylor Rule still suggests rates at around -3%, so the main message continues to be that rates should get down immediately to their floor, and then other extra-ordinary easing measures should be employed. I continue to regard 0.5% as a natural floor with a corridor of 50 bp. I am still searching for arguments why the deposit rate cannot be zero, and for arguments why a wider corridor than 50 bp is needed. I am somewhat sceptical about the wisdom of purchases of private assets, so I would prefer the purchases of sovereigns. Alternatively, or additionally, I would advocate further lengthening of the maturities for the repo facility and possible easing of collateral requirements with smaller haircuts.
Eric Nielsen is European Chief Economist of Goldman Sach in London

Jacques Cailloux

Economic activity in the euro area likely contracted by an even larger amount in Q1 than in Q4, something which I clearly did not expect only a few months ago. Available indicators for Q2 point to ongoing contraction, albeit hopefully at a smaller pace.While a smaller contraction is good news, it still implies that the output gap will continue widening and that disinflationary pressures will continue increasing. Assuming that potential growth in the euro area has declined to about 1.5% on the back of the financial crisis, the output gap will have widened by around 8 percentage points by the end of 2010 (assuming flatish output that year). This is the largest peace time build up of slack and compares to a widening of the output gap of around 17 percentage points during the great depression. The disinflationary pressures coming from the labour market will grow over the coming months at a time that headline inflation will fall into negative territory. The combination of these developments could push inflation expectations down to unconfortable levels. The ECB should pre-empt these developments and cut aggressively to 0.5% as I suggested last month. In fact, Taylor rules for the ECB currenlty signal that the policy rate should either be already in negative territory or go into negative territory in H2 this year. In that context, the ECB should explain more clearly why it is so convinced that a below 1% refi rate would be so detrimental.

At the same time, the ECB should provide additional support to the real economy by purchasing private debt instruments, from corporates in the first instance and perhapds from households in a second instance (though the latter might be more difficult to implement as the RMBS market is very heterogenuous across the region). Corporate debt purchase looks easier to implement: to be sure euro area corporates fund themselves in a variety of ways preventing the ECB from following other central banks like the FED in for example announcing a CP purchase program. Indeed, countries like Greece do not rely on CPs for corporate funding. One way to go around this problem would be to delegate to the Eurosystem the choice of instruments to buy. In effect, the ECB could announce a purchase programme of a certain amount without specifying the type of instruments to be bought (apart perhaps from the fact that they would need to meet the current eligibility criteria). The ECB would then allocate the amounts to Eurosytem CB's applying its capital key, letting each local central bank decide which type of debt instruments to buy. This would also deal with the fact that credit conditions might vary between countries and thus require different responses. Some countries could decide to purchase instruments at different speed with a view to respond to local conditions. A bold decision of that kind would reassure observers about the capacity of the ECB to tackle the current credit crisis.
Jacques Cailloux is European Chief Economist of Royal Bank of Scotland in London

Jose Alzola

As the economy continues to contract and underlying price pressures are well below 2%, I believe another decent rate cut is warranted. At the same time, there are signs that the economy is not falling this quarter as fast as in the previous six months, as a massive global stock correction is ending, and the first impact of the economic stimulus measures and the stabilizing effect of lower inflation are feeding in. Given also that the main impact of the stimulus measures is still ahead of us (domestically and globally), I believe that the downside risks to growth are diminishing, favouring no bias going forward. I do not believe that a 1% floor for the policy rate is sensible as a general rule. After all, Euribor rates are key channels of transmission of policy rates to the real economy, and a decline below 1% may be necessary if growth and inflation outlooks are very weak (as is the case now). The argument that such action would push EONIA rates close to zero and kill the money market may be true but that is only a technical issue whose importance dwarfs in comparison to the primary goal of kick-starting the economy and taking underlying price pressures back up close to 2%. While I do believe that the ECB will have to keep rates very low for quite a long time, I advise strongly against making an explicit time commitment, because it would tie the hands (or eventually undermine the credibility) of the ECB if there is a need to start raising rates earlier than expected. The Fed’s experience earlier this decade is illuminating.
Jose Alzola is Senior Economist of The Observatory Group

Stephen King

In the discussion about green shoots, the missing ingredient is the remarkably low level of activity. According to the OECD's interim report, the output gap for the euro area will widen to 8.2% in 2010. While I have serious doubts about the reliability of output gap estimates, the message is nevertheless extremely disturbing: at these levels of activity, insolvency and unemployment are major risks, as is outright deflation. Given these huge output losses, I'd like get to a point sooner rather than later where the ECB can say that rates have fallen as far as they can and that, from now on, the focus will be on unconventional measures. If that means cutting the deposit rate to zero, so be it. The purchase of newly securitized loans would be a welcome step forward. As a Committee, we should increasingly be emphasising the need for the ECB to play not just its traditional role as guardian of price stability but also to take its lender of last resort role more seriously in these difficult times for credit markets.
Stephen King is Chief Economist of HSBC in London

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