Limited impact of looser monetary policy

The ECB’s announcement of extra financing for banks is welcome, but the marginal benefits of easing monetary policy seem to be diminishing. It may be time to wait for the existing measures to take effect.

11 March 2016

Rory Bateman

Rory Bateman

Head of UK & European Equities

Eurozone data over recent weeks has been disappointing and market expectations were for the European Central Bank (ECB) to make a notable response at the 10 March meeting.

The policy measures were indeed substantial but a disappointing market reaction indicates concern around the effectiveness of ongoing monetary expansion.

Radical change

As expected Mario Draghi delivered a 10 basis point cut in the deposit rate from -0.3% to -0.4%.

The scale and scope of quantitative easing (QE) was increased substantially from €60 billion to €80 billion per month with investment grade corporate bonds1 now included in the purchase programme.

In addition Draghi highlighted a continuation of QE and very loose monetary policy until the 2% inflation target is achieved.

Perhaps the most radical change came in the form of ‘TLTRO II’ – another round of targeted long-term refinancing operations whereby the banks will be paid to take financing from the central bank depending on the size of their loan books.

The rate they pay (i.e. receive) can be as low as the deposit rate of -0.4% depending on how much credit the banks extend.

This is uncharted territory that offsets the pain from negative interest rates that the banks have been complaining about and is designed to further stimulate lending to the real economy.

The ECB’s growth forecasts were reduced from 1.7% to 1.4% for 2016 whilst the headline inflation forecast for this year was also reduced to just 0.1%, primarily given the decline in energy prices.

Growth is slow, not stagnant

The initial market reaction was a reflection of the concerns around the effectiveness of further loosening of monetary policy given the apparent lack of impact since the programme started in the first quarter of last year.

Whilst we acknowledge global growth forecasts over recent months have come under pressure, largely because of China (though inevitably Europe has not been immune), we would refute the idea that Europe is entering a deflationary environment and stagnant growth at this stage.

We may well be in a situation where we need to wait for the benefits of the current programme to feed through.

There has been an improvement in growth across the eurozone which we expect to continue.

Many of the recent surveys we’ve seen were carried out during the volatile period in the first part of this year and do not reflect the underlying gradual recovery we are seeing in Europe.

Volatile markets

Markets across the board are susceptible to sentiment swings. Just a few weeks ago there was massive pessimism around excess inventory in the oil sector, only to witness over the last week or so optimism around declining US production.

Recent market moves suggest that China will avoid a hard landing, to the extent that we recently saw a 20% bounce in the iron ore price in one day.

The volatile short-term trading dynamics and sentiment are exacerbated by a lack of liquidity as market makers and the sell-side are squeezed by the regulator and onerous capital requirements.

Looking to the long-term

If we are to make any sense of what is going on we have to look at the fundamentals and try not to get wrapped up in the daily volatility across every asset class.

As we stated in February, we felt the declines represented a market correction rather than a dramatic change to the underlying economy.

We try to make sense of companies and sectors by looking at the real drivers of their businesses, and ultimately their share prices, rather than second guessing what everybody else is doing.

Given this view it seems that Mario Draghi may be wasting his time trying to respond to short-term headline inflation data.

Over the last two years crude is down 65%, copper down around a third, soybeans -40%, sugar -20%. It is therefore hardly surprising that there is downward pressure on inflation.

The year-on-year comparisons will begin to normalise and the picture should significantly improve. The deflation we’ve seen is good for consumers because it puts money in their pocket.

We have in fact seen fairly decent retail sales and consumer confidence surveys over recent quarters and bank lending is picking up, albeit slowly.

Wait and see

We welcome the TLTRO II which helps offset the negative interest rate environment for the banks, but it seems the marginal benefits of continued monetary loosening are diminishing.

We may well be in a situation where we need to wait for the benefits of the current programme to feed through.

We accept that if the economy stalls or the core inflation numbers deteriorate substantially from here then we may need to literally resort to the printing press or manufacture a fiscal injection that is acceptable to the core eurozone members.

1. Investment grade bonds: The highest quality bonds as assessed by a credit ratings agency. To be deemed investment grade, a bond must have a credit rating of at least BBB (Standard& Poor's) or Baa3 (Moody's).


Rory Bateman

Rory Bateman

Head of UK & European Equities