With Euro area growth coming in on the weaker end and core inflation still stuck at 1%, economic stimulus is clearly needed. The European Central Bank (ECB) is set to deliver an easing package on Thursday that could include a rate cut with an associated mitigating mechanism, perhaps a restarting of Quantitative Easing (QE) and extra forward guidance.
It is hard to love the EUR but also equally remarkable that the EUR has escaped significant battering so far despite economic weakness in the Euro area.
The muted EUR downtrend, especially when measured against a basket of currencies of the Eurozone’s major trading partners, and not just the USD, is in contrast to the run-up to the previous ECB meeting, which saw the EUR’s sharp depreciation between Draghi’s pivotal Jackson Hole speech in August 2014 and the onset of the ECB’s QE in January 2015. Admittedly, easing by major central banks including the Fed has made it difficult for the EUR to weaken meaningfully in recent months, unlike in 2015 when the ECB and Fed were headed in different directions, and the latter had already ceased QE and edging closer to a rate hike.
EUR weakened aggressively ahead of ECB QE1 in Jan 2015 but not this time
Source: Bloomberg, Bank of Singapore
It is also difficult to drive the EUR weaker amid risks of a “not dovish enough” ECB. With Mario Draghi’s term as president of the ECB ending in October, it is possible that Draghi would be looking to do just enough to avoid disappointing, rather than outdo easing expectations while leaving any major monetary policy innovation to his successor Christine Lagarde.
However, speculation of “not dovish enough” ECB also reflects the uncomfortable reality that there is little room to cut interest rates much further. In this regard, the ECB is starting to resemble the Bank of Japan (BoJ) in facing greater limits to monetary policy easing.
The Fed still has some room to cut before the rate hits zero but the ECB has no such luxury as the policy rate – at -0.4% -- is already negative. It is also difficult to see how much lower the yields of long-dated bonds could dip below their current levels. A quarter of all government bonds globally -- and over half in Europe -- have negative yields.
Moreover, cutting interest rates deeper into negative territory could add to worries that monetary policy may do more harm than good given the potentially unpleasant side effects, which range from worsening inequality to adverse consequences for savers and banks’ profitability.
The ECB cannot be the only game in town. Better would be coordinated monetary and fiscal actions. This comes at a time when incoming ECB President Lagarde has emphasised the cost/benefit analysis of monetary easing and the importance of fiscal stimulus. All eyes are on whether Germany would turn on the fiscal taps. The German Finance Minister has confirmed a 1.5% GDP in fiscal space -- even though the plans so far don't seem geared at near-term demand management.
Shifting policy mix to rely more on fiscal stimulus in cushioning downside European growth risks has the advantage of defusing US President Trump’s protectionist threats against Europe. Trump has been openly critical of Draghi’s plan to provide monetary stimulus, which could trigger possible retaliation from the Trump administration if easing by the ECB causes the EUR to decline significantly.
Will the Eurozone policy mix change? This is an important question for the EUR given that prospects for fiscal easing may increasingly determine its fate. Unfortunately, although we are seeing some modest loosening of the fiscal purse strings, the political willpower for fiscal stimulus is limited for now.Disclaimer applicable to recommendation
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