The ECB is widely expected to cut its main refinancing rate tomorrow by 25bps to a new record low of 0.5%. Amid continued economic weakness in large parts of the euro area, along with a softer-than-expected global backdrop and a marked fall in energy prices, euro area CPI inflation in April plummeted to 1.2%Y/Y, a more than three-year low. This, together with another drop in business sentiment in April, is likely to force the ECB into unchartered interest rate territory.
At the heart of the recent deterioration in the euro area’s growth prospects lay worrying developments at the euro area’s core. While sentiment broadly stabilised in the periphery over the past two months amid a further improvement in financing conditions, hoped-for recoveries in Germany and other core economies have faltered, raising concerns about the ability of the euro area to exit the crisis on a lasting basis.
ECB harmonised competitiveness indicator*
*Real trade-weighted effective exchange rates deflated by whole economy unit labour costs. Source: ECB
For example, inflation in Germany dropped to 1.2%Y/Y in April, below the level in Portugal, Italy and Spain. Low inflation in the core increases the extent to which the periphery has to lower prices and wages to close the competitiveness gap that emerged ahead of the crisis. The ECB’s competitiveness indicators illustrate this problem (see chart). Despite record employment levels, wages in Germany have remained relatively subdued, resulting in an improvement in Germany’s labour cost competitiveness since the outbreak of the euro area’s sovereign debt crisis in 2010. Only thanks to sharp falls in unit labour costs has the periphery’s competitiveness improved by more than that of Germany over the same period. But the low wage growth in both core and periphery has taken its toll on domestic demand.
Stronger growth in the core will be the only way to minimise the risk that deflation could take hold across the euro area. With prices and wages in the periphery expected to continue to fall in coming months (and possibly years), euro area CPI inflation can only remain close to the ECB’s target of “close to, but below 2%” if inflation in Germany does not fall significantly further.
Moreover, with domestic demand weak, exports will be vital for the periphery if it is eventually to return to growth. But last year, Spanish and Italian exports to Germany fell 5% and 9% respectively while private consumption in Germany grew by a meagre 0.6%. And a lack of demand also seems to be the main problem for small and medium-sized companies (SMEs), with a recent ECB survey showing that there are more firms in Italy, Spain and Portugal struggling to find customers than access credit.
All of this suggests that, given the deleveraging in the periphery, which will remain a drag on growth for the foreseeable future, the ECB should focus on stimulating demand in the euro area’s core. With financial market conditions having continued to normalise, lending rates increased in Germany at the start of the year. This is why an interest rate cut makes sense.
With the monetary policy transmission mechanism still functioning in the core and lending having stagnated, banks are likely to pass on their lower refinancing costs to customers, thereby providing greater incentives for households and companies to borrow. And by cutting its refi rate, the ECB would send a strong signal that rates will stay at record low levels for some time to come.
Of course, this is not to say that the ECB should not also do more to crack the credit crunch in the periphery. Around a quarter of all SMEs in Spain, and about a fifth in Italy and Portugal, report access to finance as their most pressing problem. SMEs in those countries have also reported an increase in bank lending rates – new loans of longer than five years are more than 300bps more expensive in Spain and Italy than in Germany. And a large share of SMEs in all member states bar Germany have recently reported, on balance, a deterioration in banks’ willingness to lend despite the improvement in financial market conditions.
By improving the terms by which banks access its liquidity, the ECB could further ease credit standards in the periphery. In its refinancing operations, the ECB imposes very large haircuts on lower investment-grade loans to SMEs (e.g. almost 50% on those of a maturity of 3-to-5 years). In contrast, the equivalent haircut applied to a Spanish or Portuguese government bond is just 7.5%, indirectly incentivising banks to hoard government bonds rather than lend.
Indeed, since the outbreak of the debt crisis in 2010, banks in Spain, Italy and Portugal have increased their government bond holdings by more than 70% despite the severe deterioration in sovereign credit-worthiness. Adjusting relative haircuts might encourage banks to shift some of their funding to the real economy, while leaving the risks to the ECB’s balance sheet broadly unchanged.
Additionally, the ECB could help revive the strained asset-backed security (ABS) market in the euro area by promising to purchase ABS backed by loans to SMEs. Since 2010 the use of ABS as collateral in ECB refinancing operations has declined by nearly 30%, while it has risen by more than 40% for government bonds (see chart below). Like with the ECB’s covered bond purchase programme, a new purchase programme of SME loan-backed ABS might spur issuance of such securities – providing incentives to increase lending to SMEs – and further enhance banks’ access to liquidity. Indeed, the ECB imposes haircuts of just 16% on marketable ABS in its liquidity operations, much less than for loans. Various ECB board members have recently expressed their preference to support the European ABS market suggesting that such an initiative could be in the pipeline.
So, there is scope for the ECB to announce a range of new measures tomorrow. Its room for manoeuvre is not limited to a rate cut to stimulate demand or fine-tuning of its collateral framework to increase bank access to liquidity. Tailor-made monetary policy measures, most notably the LTROs and the OMT, have proved to be successful in the past. Given the recent deterioration in the economic outlook, further imaginative measures, which could be similarly successful, cannot be announced too soon.
Collateral used at ECB liquidity operations*
*Other marketable includes corporate bonds. Non-marketable includes fixed-term deposits of eligible counterparties, residential mortgage-backed securities and credit claims. Source: ECB
Tobias S. Blattner, Euro area Economist