ECB to Get 'Heavy' in March as Money Supply Data Confirms the EZ Economy is Slowing

A string of poor data releases, deflationary forces and slowing money growth are increasing expectations of a more formidable policy fight-back from the ECB than markets are expecting. 

Pressure on the ECB to increase its stimulus measures in a material way is growing.

Poor data, including negative PMI’s in February and German Sentiment data hitting four-year lows is flashing warning signs that the euro-zone economy is keeling. 

Bundesbank President Weidmann who has often resisted more stimulus from the ECB said this morning that "it is clear developments warrant stimulus review," and "ECB policy must be powerful and effective."

While he warned that any measures mustn't be counterproductive, it is becoming increasingly clear that one of Europe's most influential monetary official is open to the idea of more easing.

"The ECB cannot afford a repeat of disappointing the market as it did at its December 2015 meeting," says a note from Handelsbanken, the Swedish investment bank.

The bank’s macro team pointed out that the euro had not depreciated at all since the inception of the latest easing programme in October 2014:

"Since the ECB started its asset purchase programme in October 2014, the trade-weighted EUR is flat."

They go on to explain that they expect a robust response at the next March 10 meeting:

"We believe the ECB will expand monetary stimulus on March 10."

According to the note markets are currently pricing in only an average 12 basis point cut in the deposit rate, which currently stands at -0.30 – which would reduce it to -0.42%.

Bank analysts at both ABN Amro and BofA echo the view, and have both been saying for a while now that they expect the ECB to use a combination of deposit rate cutting, probably by 10 basis points (to -0.4%), and an increase in the asset purchase scheme by an additional 10 billion euros per month.

Fixed Income Strategists at Banca IMI, however, point out that a lack of supply of eligible bonds may put a cap on the size of the ECB’s ambitions for its QE programme going forward:

“The market expectations that the ECB may decide in the first months of next year to step up monthly purchases of government bonds seem unrealistic by all accounts, given the serious constraint already imposed by the size of the German market.”

In December, the ECB went some way to addressing this problem by widening its remit of eligibility to encompass municipal bonds, adding more inventory after it lengthened the programme to March 2017.

It has also increased the maximum share it can own of any one security to 33%, from 25% previously, further adding supply, however, core stock remains a problem.

Indeed writers Gerba and Machiarelli have pointed out in a recent policy paper, that cutting the deposit rate has the consequence of also making more bonds eligible:

“Cutting the deposit rate further was indeed tailored to make more bonds eligible for QE purchases.”

Even if there is still a lack of adequate supply, the ECB may use another policy measure to tackle the problem, which would be widening the eligibility criteria to include other assets such as equities or corporate bonds, after all, ECB President Mario Draghi did hint at a wide spectrum of possibilities when he said the options were “limitless.”

Economy Losing Momentum

Early hopes that the euro-zone economy may be ‘back-on-track’ and displaying ‘green-shoots’ of recovery came on the back of a recovery in mostly the housing and labour sectors, particularly in hard-hit peripherals such as Spain, where house prices recently showed substantial traction higher.

However, inflation data showed a substantial decline in December resurrecting the spectre of deflation, and this has prompted the ECB to “review and perhaps reconsider” its monetary policy stance in March.

The main issue at stake is how much of the deflationary pressure is due to a ‘pass-through’ from the falling price of commodities, especially oil and gas, and therefore temporary, and how much is due to a deeper, structural problem such as lack of demand.

Sadly, it seems that recent Euro-zone PMI data for February, has shown that the ‘pass-through’ effect from cheaper commodities is not the only factor in determining the fall in prices, as Services PMI also saw a fall in prices and it is relatively unaffected by falling input costs.

According to the accompanying report, the reason for falling services prices was more due to decline in demand and intense competition rather than input costs, lower commodity prices or global worries.

This may have gone some way to answering the ECB’s question about the roots of the current fall in inflation pressures, with the conclusion that the monetary policy need to be robust to meet the deeper underlying problems continuing to bewitch the region’s economy.

A string of recent sentiment data releases showing increasing pessimism in the region has also probably further increased pressure on the ECB to act in a stronger way.

Money Supply Falling

Adding to signs that the ECB's quantitative easing measures and rate cuts are failing to stimulate lending are data showing money supply to the economy continues to fall.

The Eurozone broad monetary aggregate M3 grew by 5.0% (annual rate) in January, up from 4.7% in December.

Meanwhile, the narrow M1 growth rate edged lower from 10.8% in December to 10.5% in January - but - It has slowed down since the middle of 2015, from an annual growth rate of close to 12%, to around 10.2% in January.

"Real M1 money growth, corrected for HICP inflation, tends to be a relatively good leading indicator for economic growth in the eurozone," says Aline Schuiling, Senior Economist at ABN Amro.

"This seems to be in line with the fact that the eurozone economy lost some momentum in the course of last year and also adds to the evidence that GDP growth probably slowed down somewhat further in the first months of this year," says Schuiling.

Quantitative Easing is Not the Only Way

A research paper commisioned by the EU Parlimentary Committee on Economic and Monetary Policy, by economists Gerba and Machiarelli, has argued Quantitative Easing (QE) may not be the most efficient policy weapon the ECB could employ.

For them the root of the economic problems in the euro-zone is the lack of bank-lending to the wider economy.

They argue this is due to the relatively high amount of Non-Performing Loans (NPL) which banks carry on their books, which then tie up credit which could otherwise be used for lending:

“High NPLs tie up bank capital that could otherwise be used to increase lending, leading to a reduction in bank profitability, a rise in funding costs and thus a reduction in credit supply overall.”

The reasons for this is the different regulation and laws governing bankruptcy in the euro-zone compared to the U.S and Japan, for example, where write-downs on bad loans are more common:

“NPLs remain very persistent in the Euro Area, where the write-off rates for banks remain much lower than for US or Japanese banks.

“According to Aiyar et al. (2015), the reasons for that can be traced back to limited tax deductibility of provisions, weak debt enforcement and ineffective bankruptcy procedures that discourage write-offs and increase the cost of recovering assets provided as collateral for loans.

“Additional reasons are rigid accounting rules that hinder timely loss recognition and a lack of a sizeable market for distressed debt in Europe.”

According to Gerba and Machiarelli’s logic, therefore the most robust response the ECB could make in March is to start to change the laws around distressed debt and bankruptcy in the euro-zone, to enable banks to start to loosen and expand their lending back into the wider economy.