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ECB to Enter ZIRP?
[B]A zero refi rate is not the most likely scenario[/B] … Several major central banks, including the Federal Reserve, the Bank of Japan and the Swiss National Bank, have already embarked on a (near) zero interest rates policy (ZIRP) (see "The Fed Lady Sings", The Global Monetary Analyst, December 17, 2008). While we would not categorically rule out that the ECB could also be forced to resort to such extreme measures, we don’t believe that ZIRP is the most likely scenario for the official refi rate. It is, however, possible for the overnight rate (EONIA – the Euro OverNight Index Average, which is the weighted average of overnight Euro Interbank Offer Rates for interbank loans), depending on market conditions. We forecast further rates cuts of 150bp in the next few months, which would bring the refi rate down to a new historical low of 1% by the spring. This marks a downward revision of half a percentage point compared to our previous profile (see Testing Times, December 3, 2008), reflecting another downgrade to our near-term growth and inflation forecasts. We now expect euro area GDP to contract by 1.6% and HICP inflation to fall to just 1.1% this year (for more details, see European Economic Chartbook: Lowering Growth, Inflation and Interest Rates Forecasts, January 7, 2009). Given that the ECB announced in late December that the corridor around the refi rate will be widened back to 100bp from January 21, a 1% refi rate implies that the floor for the overnight rate would hit the zero threshold. Another cut in the refi rate could come as early as January. After the 75bp cut in the official refi rate at the early December meeting, a further 50bp stealth-easing brought about by a cut in the deposit rate announced in late December, and a range of diverging comments from various ECB Council members, it is far from clear whether the ECB is ready to ease again this month. However, the recent data flow, which showed further sharp falls in business sentiment and a marked decline in inflation, underpin the case for another 50bp rate cut, we think. ECB reluctant to 'go all the way' for several reasons. A number of ECB Council members have expressed concerns about complications that can be created by very low interest rates. Hence, we sense some resistance with respect to ZIRP on the part of the Governing Council. Historically, the ECB has drawn a line at 2%. In many respects, we are in uncharted territory though. Hence, we believe that the ECB will cut the refi rate to a new low of 1% in the current cycle. But, in our view, the ECB’s enthusiasm for further rate cuts will likely peter out before the refi rate, which is key for term funding, gets to zero. That said, with the broader corridor around the main refinancing rate and generous provision of liquidity to the banking system by the ECB, the EONIA overnight rate hitting zero – a ‘secret’ ZIRP strategy, if you will – cannot be ruled out. For several reasons, the ECB is less enthusiastic about ZIRP and ‘targeted’ quantitative easing than the Fed. We discuss these reasons below, and highlight some potential policy alternatives: [B]• The first reason lies in Europe’s history.[/B] Monetary policy in continental Europe is still shaped by the experience of the German hyperinflation of the late 1920s and probably less so than in the US by the Great Depression. The malfunctioning of fiat money during the Second World War, a post-war currency reform in Germany and empty-shelf experiences in many communist countries still make policymakers and the general public aware of the situations where money doesn’t buy much anymore. [B]• The second reason is the state of the economy.[/B] While the euro zone cannot escape the global recession, the risk profile around the base case is different to that in other major economies. This is because the euro zone remains considerably less levered than the US or the UK, especially in the household sector. On aggregate, the region has not seen a build-up of major imbalances, a sharp fall in the household saving rate or the emergence of a large current account deficit. As a result, a multi-year slump to work off some the past excesses is a more remote scenario for the euro area than it might be elsewhere. The lower level of private sector debt, the relatively high and stable saving rate and a diverse financial system suggest that the dangers of a debt-deflation spiral might be more limited in the euro area. True, HICP inflation could easily dip into negative territory next summer – depending on oil price developments. But, on our projections, this fall is likely to be reversed relatively quickly in the latter part of this year. [B]• The third reason concerns the practicalities of ZIRP.[/B] A very low level of interest rates poses some operational challenges. These challenges include lower incentives to lend securities in the repo market, increasing difficulties for money market funds to pay positive returns and rising margin pressure for lenders. All of these factors can cause lending to dry up even further, exacerbating rather than alleviating the problem. Some of these undesirable side effects can be avoided if ZIRP were supplemented by ‘targeted’ quantitative easing, fiscal stimulus and financial sector reform. [B]• A fourth reason for the ECB’s reluctance to embrace ‘targeted’ quantitative easing is institutional.[/B] Outright purchases of financial assets, which lie at the heart of 'targeted' quantitative easing, allow circumventing of the banking system and extending credit directly to the government or the private sector. While the ECB has been pursuing a two-pronged strategy of cutting interest rates and expanding its balance sheet, it hasn’t bought securities on an outright basis yet. One factor holding the ECB back, even though it can, in principle, buy securities outright, is that financial losses from such outright purchases could undermine ECB (financial) independence. This obstacle could potentially be overcome if finance ministers provided an ex-ante guarantee to cover potential losses. 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