With headline consumer price inflation back below zero and inflation forecasts being revised down, we expect the European Central Bank (ECB) will deliver a little bit more of everything at its monetary policy meeting this Thursday: more liquidity, lower rates, more quantitative easing (QE).
- More liquidity. The easiest thing for the ECB will be to offer banks more liquidity. We think they will do so by either dropping conditions on the remaining targeted longer-term refinancing operations (TLTROs) or offering new 3-year to 5-year LTROs without conditions.
- Lower rates. It is possible the ECB goes only part-way on Thursday – e.g., by cutting the deposit facility rate to -0.4% and the main refinancing rate to 0%, and increasing its QE programme to €65 billion per month from €60 billion. But given the persistent decline in actual inflation as well as measures of inflation expectations, we still would expect the central bank to be more aggressive, as outlined in Figure 1.
We think the ECB will be very cautious about lowering the deposit facility rate below -0.5%. Deeply negative policy rates could have more costs than benefits for the broader economy, particularly for banks in peripheral countries whose loan books are more sensitive to the Euro Interbank Offered Rate, or Euribor.
Negative rates lower the profitability of the banking system, which could blunt the transmission of monetary policy were it to become too extreme. Banks’ cost of long-term capital could rise if investors become wary about the viability of their business model. In turn, the banks’ attempts to maintain profitability could paradoxically result in higher interest rates on mortgages and loans. Evidence from Sweden and Switzerland suggests this could also happen in the euro area. In a large open economy like the euro area, negative interest rates work in similar ways as foreign exchange intervention in weakening the external value of the currency, only in disguise. So long as banks do not pass the negative rates on to retail depositors, who may hoard cash, they shelter households from the incentive structure of paying to save.
- More QE. We think the ECB is close to exhausting its room to manoeuvre on interest rates and if more easing is required, QE will have to play a bigger role, rising to €70 billion per month.
Our baseline forecast for the ECB’s policy stance this year is presented below in Figure 1.