ECB Outlook: Mostly Thunder, Little Chance of Rain

The ECB meets next week.  After cutting the repo rate by 25 bp earlier this month, and officials playing up the scope for additional action, expectations are elevated.  However, when everything is said and done, more will likely be said than done.  Specifically, barring a significant surprise on the CPI due at the end of this week or some kind of shock with the PMI, we suspect expectations for action will likely be disappointed.  

As a newswire report played down the chances for action, the euro spiked up to almost $1.3550, but quickly came back off, returned to the lows.  It has since chopped back to the highs.  We peg immediate resistance near $1.3580, last week's high, and then $1.3630, before taking a serious look at $1.3830, the year's high set last month. 

It is in the ECB's interest to play up their options and drive the message home to investors that their resources have not been exhausted.  However, as we have argued, none of the options are particularly appealing.  Another LTRO is likely to seen minimal participation ahead of the ECB's stress tests.  Another cut in the refi rate to bring to zero might lower dampen overnight rates a bit, but they are already very low (except during the run up to the end of the reserve period and the end of the month).  It is unlikely to boost lending or arrest disinflationary headwinds. 

The ECB can boost excess liquidity by reduced the required reserves.  However, may not boost lending.  European banks are continuing to de-leverage and the new regulatory demands appear to be an important driver.  The ECB can only make current collateral more effective by reducing the haircuts imposed or widening the acceptable universe, but may also not be particularly effective is boosting lending, or addressing the financial conditions more broadly.  

While the ECB has acknowledged it is technically and legally ready to have a negative deposit rate, most officials seem clearly and understandably reluctant to take this unprecedented step.  Yes, a couple of countries like Denmark and Sweden have had negative deposit rates, but not major central bank has, including Japan, despite yesterday or ZIRP (zero interest rate policy).    Not only are there intended and unintended consequences, but there are foreseeable and unforeseeable consequences.  It could potentially further squeeze the very same banks that the ECB would like to boost lending.  

Outright bond purchases, as in a genuine quantitative easing program, while theoretically possible, are highly unlikely.  It would seem to violate some key agreements.  That Germany feels quite adamant was evidenced by the resignation of not one, but two, German members of the ECB in protest to Trichet's sovereign bond purchase program (SMP).   Remember, the German Constitutional Court ruling on OMT is still pending and expected in Q1 14.  

At the ECB meeting, new staff projections will be announced.  The current forecasts include a 0.4% contraction to this year's GDP and a 1.0% increase next year.  Next year's forecast could be shaved.  The more substantial changes will be in the inflation projection.  The CPI forecast currently stands at 1.5% this year and 1.3% next year.  October CPI was 0.7% year-over year.  The ECB staff may nearly halve this year's forecast and sharply cut next year's.  On Friday, the Nov series will be released.  It is expected to tick up to 0.8%.  Next week the ECB will also extend its forecast to 2015.