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The European Central Bank is facing a big dilemma:  should it act or should it wait?  Euro-zone inflation is low, but off the bottom. The exchange rate is high and very uncomfortable for exports and for inflation but it also reflects trust in the euro-zone.

There is a lot of uncertainty towards the big event that will set the next significant move of EUR/USD. Here is some background and 4 scenarios.

Missing the target

The ECB has  one mandate: inflation of “2% or a bit below” in headline CPI inflation. The target is being missed month after month. Low inflation, also known as “lowflation” makes the debt burden heavier, makes it harder to exit the situation and leaves the danger of the dreaded deflation.

Draghi and co. want to avoid a  vicious cycle where falling prices discourage consumption, which in turn lowers  production, jobs are lost, consumption falls again, etc. This is what happened in the Great Depression of the ’30s and what happened  in Japan’s two “lost decades”. Japan is now fighting deflation using all available means.

Lowflation

The deterioration began in October with  CPI falling to 0.7%. The ECB reacted with a surprising rate cut of the main lending rate to 0.25%. Since then inflation  bottomed at 0.5% in March, rising back to 0.7% in April (preliminary numbers). Core inflation hit 0.7% twice and climbed back to 1% in April.

ECB members have been busy denying deflation but admitting that if “lowflation” stays for too long, it will be hard to escape it.

Worsening conditions

Later on,the focus gradually shifted to the exchange rate. A strong euro means less competitive  euro-zone exports and cheaper imports which push prices down. Moves towards 1.40 in EUR/USD were welcomed with warnings from the ECB, yet it is important to note another currency pair: EUR/CNY.

China is a big trade partner of the euro-zone. The authorities in Beijing began  weakening the local yuan against the dollar after a long period of  appreciation. This in turn means that EUR/CNY is at levels last seen in 2011.

Talk becoming cheap

The ECB went from  dismissing the exchange rate by saying it isn’t a policy target to  expressing worries. This continued with  strong  implicit warnings such as declaring that the governing council is “unanimous about the use of non conventional monetary policy tools” (mentioning QE) to  Draghi  explicitly  connecting the exchange rate to further monetary  stimulus.

The first time that Draghi said it resulted in a big Sunday gap. However, the second mention had a  short-lived effect. Markets want action, not words.

In a perfect world, Draghi would lower the euro with words and without action. This way, the ECB keeps all the “non conventional”  tools after already lowering the main interest rate to 0.25%. This worked with the European debt crisis: Draghi’s “everything it takes speech”, followed by presenting the OMT restored trust. However, now it comes to backfire, with the strong exchange rate.

So what will Draghi do?

4 scenarios

  1. Interest rate cut: In this scenario, Draghi cuts the main interest rate to 0.10 or 0.15% without moving the deposit rate from 0%. This will have a marginal effect on the real economy but could have a  symbolic effect: it will go to show that the ECB  can also act and not only talk. It also leaves the bigger tools at hand and doesn’t anger the orthodox German Bundesbank that fears inflation. The result would probably be a  weaker euro at first but without a long term affect. It could be an opportunity to “buy the dip” – a  common pattern for EUR/USD  trading. A stronger effect on the euro would come if  Draghi accompanies such a move with even stronger words. This compromise move has a high probability.
  2. No action, just words: This scenario is mentioned by many analysts. Draghi can refrain from action and paint a rosy picture of the euro-zone recovery and the  recent rise in inflation as significant. He could still offer threats but without wasting any tools but risking deflation. In this scenario, the euro could dip initially on Draghi’s rhetoric, but could certainly jump afterwards,  easily breaking 1.40 on the lack of action. This scenario has a medium-high probability.
  3. Negative deposit rate: the ECB could announce a cut in the main rate to 0.15% and set a negative deposit rate of -0.10%, thus  maintaining the 0.25% corridor between what  banks pay for lending money and the rate they get when parking money with the ECB. A negative deposit rate means banks are “punished” for keeping the money with the central bank. In theory, this should encourage them to lend money out to the real economy.  It could also serve to drive some money out of the euro-zone, thus causing a  long term negative effect on the exchange rate. While the ECB has mentioned it is “technically ready” to do so for a long time, such a move can have unintended  consequences: it can drive too much money out of the euro-zone. A negative deposit rate has not  been used on a large scale. A worse scenario is that it doesn’t work, meaning that the tool is gone without any effect. In this scenario, which has a medium probability, we can expect a big fall in the euro followed by a long period of weakness.
  4. QE: The ultimate non-conventional tool has been in extensive use in the US, the UK and Japan. If the ECB  announces buying bonds and flooding markets with money, it faces a different situation than the  aforementioned countries: which bonds should it buy? There are no eurobonds and the euro-zone consists of 18 countries. Other scenarios include buying US bonds (thus weakening the euro) or even gold. Due to the complexity of such a move, potential legal challenges regarding monetary financing and Bundesbank objection, this will probably be left as the last tool. However, it cannot be ruled out as the ECB recently published a job offer regarding managing a portfolio of bonds. In this scenario, which has very low probability, we can expect a total crash of the euro.

What do you think the ECB will do? Will it act or not? Where will EUR/USD stand in the aftermath of the decision?

The ECB announces its  decision on Thursday at 11:45 GMT. Draghi begins his press  conference (from Brussels this time) at 1230 GMT.

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