• State Street's May Investor Confidence Index (ICI) revealed that European investor confidence rose last month in anticipation of action from the ECB this month (the European ICI rose 9.3 points to 111.2)
• Expectations of an ease in policy at tomorrow's meeting are high
Comment from Michael Metcalfe, head of global macro strategy at State Street Global Markets: 'The ECB: A conventional solution to an unconventional problem'
Expectations of an ease in policy at this week's ECB meeting are high. But there is little agreement on the form easing will take. Conventional options are a small interest rate reduction or FX intervention to weaken the Euro. Unconventional options are also on the table ranging from negative deposit rates, funding for lending, another LTRO, all the way to outright quantitative easing.
The challenge the ECB faces is rather unusual. It is essentially a problem of the current inflation rate being too low. This risks generating deflationary expectations and thereby hindering a recovery which is by and large proceeding as the ECB forecast. Rather than set policy to achieve the inflation target in two years’ time, the challenge is to prevent or even reverse the recent run of negative inflationary surprises.
This unconventional problem does not necessarily have an unconventional solution. Both QE and negative interest rates act through a signalling channel (the central bank 'will do what it takes') and through portfolio balance effects, investors are encouraged to move out of cash balances or safe government bonds into riskier securities. They impact sentiment and animal spirits, which should eventually feed through into the real economy, but the immediate impact on inflation is unclear unless the policy also leads to depreciation in the Euro.
As Callum Adams-Carr has detailed previously, analysis of the link between the Euro and our real time inflation data suggests a surprisingly quick pass through from Euro movements into prices. This suggests that engineering a depreciation of the Euro could provide just the short-term boost to inflation the ECB needs to ward off deflation fears (Figure 1). While the other policy options on the table could all in theory also produce such a depreciation, the more conventional policy of FX intervention would be far more direct without the potential complications of either negative deposit rates or QE. Like the other moves, it is easily justifiable in the name of the ECB's inflation mandate and, as we've learned with the OMT, when the ECB does this they have a high degree of credibility and market impact.