ECB Holds Fire For Now, But QE May Be On The Way

BMI View: The European Central Bank continues to toe a cautious line and left its policy instruments unchanged at the April 3 monetary policy meeting. However, a noticeably more dovish tone from ECB President Mario Draghi and indications that some form of quantitative easing is a possibility, suggest that the central bank is paving the way for fresh monetary stimulus. Although Draghi is still downplaying the need to go down the road of QE, a slew of weak inflation prints and the possibility of a looming crunch in bank funding markets could ultimately force the ECBs hand.

After the European Central Bank disappointed the growing legion of voices calling for further policy rate cuts in March, the decision to hold fire again at the April 3 monetary policy meeting was not particularly surprising. However, in the follow-up press conference, ECB President Mario Draghi indicated a clear change in tone within the Governing Council and hinted that more radical measures were being discussed, including some form of quantitative easing. We have been arguing for a while now that in light of passive monetary tightening (as a result of banks repaying LTRO funds), a strong euro and still broken credit transmission channel, the ECB would need to up the ante and deliver a sizeable monetary stimulus to the beleaguered eurozone. We have also suggested that the Asset Quality Review would likely limit the take-up of another big LTRO round because of the potential stigma of acquiring funds from the ECB at a time when bank balance sheets are being scrutinised. As such, we have expected some combination of policy rate cuts, forward guidance and small-scale LTROs.

The prospect of the ECB indulging in some form of quantitative easing is by far and away the most important policy development since the Outright Monetary Transactions facility was announced back in September 2012. Early on in the eurozone sovereign debt crisis, we argued that a key pillar of any credible and sustainable crisis resolution policy would be discretionary monetary intervention in the sovereign bond markets of the sort pursued in the US and UK. The OMT announcement proved particularly powerful in stabilising the bond markets and effectively kicked QE into the long grass. Despite the success of the OMT, we have warned that the strict conditions attached to any ECB purchases of sovereign debt, coupled with uncertainties about how such a policy would be implemented (for example, would the central bank risk destabilising markets by withdrawing support if the target member state failed to meet its fiscal and economic reform targets?), could ultimately render the pledge ineffectual. With that in mind, and given that the broken credit transmission channel means that successive LTROs would run into diminishing returns to economic growth, quantitative easing would offer the best chance of delivering a meaningful stimulus to the eurozone.

Policy Rates Unchanged At April Meeting
Eurozone - ECB Policy Rates, %

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