Draghi’s dilemma: monetary policy options

While still denying any deflation concerns, Mario Draghi has admitted that the longer the inflation rate remains below target, the harder it will be to achieve the mandated price stability.

Inflationary pressures eased again in February, with businesses reporting that the prices they pay for raw materials and other inputs have fallen for the first time in six months. Most have increased the prices they charge customers only marginally, and at the slowest pace since October.

Consumer prices growth

The European Union's statistics office Eurostat said on Friday that consumer prices in the eurozone grew 0.8% in February from a year earlier, well below the European Central Bank’s target of just below 2%. What is interesting is that, before the Committee on Economic and Monetary Affairs in Brussels on Monday, Mr Draghi mentioned foreign exchange rates. There has always been a tendency to shy away from this particular measure when it comes to rate setting, so the fact he brought it up is somewhat prescient in my view. 

For now, the euro is below a big resistance level – 1.3830 – where there is a tendency to the downside. That said, over the past few quarters the single currency has been somewhat correlated to risk and equity upside. With a degree of growth (albeit subdued) emanating from Europe, coupled with the capital outflow from emerging markets, we could well see the euro target the $1.40 level. This would create issues for export-led economies. Even against the pound, the euro is probably stronger than it should be if we are to nurture the recovery. 

Better-than-expected eurozone data

It is important to note that manufacturing PMI for the zone announced earlier was stronger than initially estimated, even if it slowed from the previous month. Italy surprised to the upside with services PMI showing its highest reading since March of 2011, with a print of 52.9 against the 49.9 expected. France, while showing contraction, saw its services PMI moderately beat expectations at 47.2 versus the consensus 46.9 figure. Ireland saw its nineteenth consecutive month of growth in the sector, albeit lower than the month before. So there is some optimism about the recovery.

This morning it was also announced that eurozone retail sales beat expectations in February, rising 1.6% against 0.8% rise expected. Essentially all we have seen here is a reversal on January declines. The moves in EUR/USD have been unexceptional as markets await direction from ECB tomorrow.

The options

The jury is still out on what path the ECB will take. 

Cutting rates to combat the lack of inflation might be counter-productive and there is, to be fair, little scope left with refinancing rates at 0.25% and deposit rates at zero. Nevertheless, the previous rate cut has probably run its course in terms of effectiveness. Given that even the International Monetary Fund has made clear that proactivity rather than reactivity is required, the markets will require some sort of move from Mr Draghi if he is to prevent an extended period of low inflation.

I do not expect a cut at this point but a signal that one is imminent is a distinct possibility. This would probably not bode well in Germany with older and wealthier savers affected and the omnipresent historical fears of hyper-inflation in that country.

More likely, we may see an end to the sterilisation of bond purchases which would address the real problem – lack of liquidity. An initiative that came about during the height of the financial crisis in a bid to ward off inflation, this would certainly deepen the liquidity available to those banks which are having difficulty in availing long-term financing.

An additional LTRO programme may be adopted, but with an added caveat that the funds be used for business lending – akin to the Funding for Lending scheme in the UK. This would have the added effect of boosting investment and would parlay into higher consumer spending within the eurozone.

If negative interest rates pose a challenge, with respect to Germany, then the mere idea of quantitative easing is something that would be extremely difficult to achieve. 

There is a risk that the euro will rally without some form of move in current policy, or at the very least a dovish rhetoric that implies action in the near term. Mr Draghi is currently treading a fine line between credibility and keeping everyone happy – which will he favour tomorrow?

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