Whatever policy measures the ECB announces at its June meeting, they will scratch the surface of Europe’s deflationary threat and the impact on the currency will be marginal at best. Here’s the underlying analysis for both views.
The issues prior to the financial crisis are well documented, but one was the fact that wage costs and prices in the peripheral nations (Italy, Spain, Greece, Ireland, Portugal) were running ahead of the Eurozone average, making their economies uncompetitive. On average, inflation rates were running 0.7% above Eurozone inflation in the period 1999-2008. Over the past year, inflation in peripheral nations has run 0.4% below the Eurozone average. In a single currency zone, for peripheral nations to regain competitiveness, the only viable option available is for a lower inflation rate vs. those core countries with which a gap in competitiveness has emerged. A narrowing of the gap via a gain in productivity is exceedingly difficult to achieve in a low (or negative) growth environment, not least because needed structural reforms are that much more difficult to implement.
Naturally, there has been a strong reluctance from Germany to accept a higher rate of inflation as a means to reducing the deflationary threat, allowing core countries to maintain a positive inflation rate. This is why it has taken until now for the ECB to be in a position where more unconventional measures can be considered.
On those measures, each will have only limited impact. We previously pointed out the limited link between ECB official rates and the interest rates paid by households and businesses (see “Why the euro will do well”). Furthermore, the impact of a negative deposit rate is going to be very limited. This is the rate at which banks are remunerated (currently zero) for parking overnight funds back at the ECB, which they do not want to lend out. The amount parked has fallen by more than 80% over the past year. Generally banks have less liquidity sloshing around, partly because they have been re-paying loans back to the ECB. The thinking is that this greater willingness to lend will push market interest rates lower, but the impact will be modest at best.
So what does this all mean for the currency? In the bigger picture, not a lot. We can either look at the euro from an interest rate perspective or portfolio (flow) perspective. The changes in market interest rates are going to be marginal. Don’t forget that EONIA and Libor rates are higher vs. the time they last cut rates 6 months ago and ECB data shows minimal net changes on interest rates paid by households and businesses (which naturally any credit easing scheme will aim to address).
Far more important for the currency has been the outperformance of Eurozone asset markets. Peripheral bond and stock markets have outperformed the US so far this year, attracting capital in a yield-starved world and once again undermining euro bearish views (we were relatively bullish in Q1 – see “The euro defying expectations”).
The bottom line is that the ECB is looking into a pretty depleted tool box, with old weapons for tackling deflation and pretty second rate new ones. As such, there are no grounds for expecting a major negative impact on the currency. Given the level of expectation that has built up, if there is any hint of disappointment next week, the euro could initially rally.