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Why is the ECB being so lame?

US Federal Reserve action throws into sharp relief the ECB's recent interest-rate timidity.

With the shock news that the Federal Reserve is keeping rates at zero until unemployment falls below 6.5%,  the ECB's decision last week to keep rates on hold has incensed/perplexed some financial observers.

In fact, the ECB is breaking the Taylor rule


JPMorgan analysts mused on Wednesday:

At its November meeting, the ECB sent a clear message: policy was very accommodative and the OMT-related improvement in financial markets would, over time, help the real economy. We saw the ECB firmly on hold.

Last week's meeting was more confusing. Draghi stuck to the same story: the policy stance was accommodative, the OMT had improved financial markets and some business surveys had ticked up. But, this sat less comfortably with the downward revision of the staff's inflation and growth forecasts. And, after the meeting, reports suggested that a majority on the Governing Council had been open to a rate cut, but that a minority of Draghi, Weidmann, Coeure and Asmussen had blocked it. One report pointed to concern that a rate cut would send a negative signal, given the weaker growth forecast. This was odd; is it not better for confidence if the central bank responds to weaker growth?

An interview in the Wall Street Journal with ECB executive board member Peter Praet suggests that no big policy shift is likely for now. Praet sees little room for further rate cuts and added that lower rates would not address problems with the transmission of the "very low" interest rates to the real economy. To him, rate cuts are not the main issue. What about liquidity and collateral changes to improve policy transmission? No, Praet sees the onus remaining on the OMT to help the real economy ("we do not see a need to come up now with new measures"). And he adds that an overly generous ECB can create moral hazard, i.e. slow down the necessary adjustments on the part of governments and banks. The central bank must do enough to prevent a bad equilibrium, but avoid doing too much.

There is also a question about how the ECB would cut rates. Last week's debate was about cutting the main refi rate (from 0.75% to 0.5%), rather than taking the deposit rate to below zero. A refi cut, together with a narrower corridor, would not have much impact on money market rates, which effectively trade at the deposit rate. The main effect would be to reduce by around €2bn per year, the cost of ECB borrowings of peripheral banks, which is not that much. A negative deposit rate would be more stimulative, reducing rates in markets, triggering a search for yield and possibly weakening the currency. Praet calls for caution though: the ECB is technically ready (i.e. its computer systems could cope with negative rates), but it could still have negative side-effects in markets (e.g. tighter bank lending conditions).

Overall, Praet's comments are closer to the tone of the November meeting: the OMT will help the real economy and the ECB is willing to wait for this, rather than rush into new policy initiatives. And, if they do cut the refi rate, they would probably narrow the corridor, rather than take the deposit rate below zero. We still think that the ECB could do a bit more to improve policy transmission using its collateral/liquidity tools, rather than just wait for the OMT to work its magic. But, the central bank does not appear minded to do anything significant in the near-term. Hence, if the next round of business surveys disappoints (starting with Friday's flash PMI), then a refi cut may be forthcoming (together with a narrower corridor), but not much else. In any case, we expect the economy to recover (see second chart) and therefore see the ECB on hold from here.

On a side note, with Bank of England governor-designate Mark Carney attacking inflation-targeting regimes and the Federal Reserve's newfound monetary revolutionary, the ECB's price stability dogma might increasingly be seen as a pre-Lehman intellectual fetish.

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