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The European Central Bank convenes in February as the level of inflation remains stubbornly low, and the economic recovery remains fragile. Will the low inflation push the ECB to cut its rates again, and this time by setting a negative deposit rate? Will the ECB use other tools or settle for hints?

This option is certainly on the table, but a move in March seems to have better chances. Here are 5 scenarios for what the ECB could do:

Update:  ECB leaves all rates unchanged, Focus shifts to the press conference.

Update:  Draghi remains calm about low inflation – EUR/USD leaps

Analysis:  ECB expects the situation to sort itself out, but things could still worsen

First, here is some background on previous moves, deflation and a negative deposit rate:

Background

The ECB surprised may market participants by cutting its main lending rate from 0.50% to 0.25% in November. The trigger for the move was undoubtedly the big drop in headline CPI (Consumer Price Index) to 0.7% for the month of October. Core CPI stood at 0.8% at the time.

By making the cut in the main rate to 0.25% but leaving the deposit rate unchanged at 0.25%, the central bank reduced the corridor between the price at which lends money out and the price it pays banks for banks depositing money with the ECB to only 0.25%. The corridor used to stand at 0.75% in the past.

Since then, CPI rose up to 0.9% and now dropped again to 0.7% in January according to the preliminary release. Core CPI stands at 0.8%. The ECB repeatedly said that it does not see a danger of wide euro-zone deflation, but rather sees it as limited to very specific countries. In addition, it does expect a long period of low inflation, but no deflation.

Deflation and a negative rate

Why is deflation bad? Falling prices are good for consumers, but if prices fall, consumers buy less, then manufacturers produce less, jobs are lost, consumption is reduced again, etc. This vicious cycle is something that is feared by many developed economies.

What does a negative interest rate do? If banks are punished to hold their funds with the ECB, there is a better chance that they will lend the money out to customers, thus boosting the real economy. This is the main argument, which is still to be seen.

The bigger, immediate effect of a negative rate is that money is expected to flee out of the euro-zone, thus reducing the value of the euro imminently. A lower exchange rate of the euro will help the economies of the zone by boosting their exports and will also push up prices of imported goods.

So far, ECB president Mario Draghi mentioned this option several times, and stated that the ECB is technically ready to act. At times, these words certainly hurt the common currency. However, if he keeps talking without acting, the effect on the exchange rate is diminished.

So, is it time to act?  

5 Scenarios

  1. No policy change, but hint of action in March: As CPI and core CPI still didn’t reach new record lows, the ECB could prefer waiting for another month, seeing how inflation evolves, while preparing the markets for this significant policy change. This option has a high probability. As such a scenario is partially priced in, EUR/USD is likely to lose ground, but not collapse.
  2. Negative deposit rate: There are chances that the ECB will not wait any longer and act by setting the main lending rate at 0.10%-0.15%, and the deposit rate at -0.10%. Some analysts support this option, which has a medium probability. Even if the deposit rate is only symbolically negative, the use of the “nuclear option”, which is not really priced in, is set to trigger a big fall in EUR/USD.
  3. Stopping SMP sterilization: The ECB has other options apart from cutting rates. One option is not to sterilize its holdings of bonds bought in the SMP program. The ECB bought some 200 billion euros worth of bonds and has been draining the money from the markets, to avoid flooding the markets. As the LTRO program has begun winding down and money supply is squeezing, the ECB could increase money supply and boost lending by stopping to drain the money from the markets. Such a move will likely hurt the euro, as it will show that the ECB is acting, and could add a negative deposit rate later on. It has a medium probability as well.
  4. No policy change, dovish comments: In this scenario, Draghi expresses worries about prices and about the recovery, but does not provide any clear hint about an imminent move. Given German fears about the inflation genie, this option cannot be ruled out, but has a low probability. The euro would make gains on such a message.
  5. No policy change, business as usual: While this option has a low probability, it cannot be ruled out due to Draghi’s “mood swings”. The ECB president tends to switch from an optimistic message to a pessimistic one every month. We saw a positive ones in October and in December (“Merry Christmas“), and negative ones in November and January. So now in February, Draghi could theoretically send a message of “business as usual” and no worries. In this scenario, EUR/USD would gain nicely.

What do you think? What will the ECB do and how will the euro react?

For more on the euro, see the Euro dollar forecast.

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