The State of Confusion and the ECB

This time last year the ECB was raising interest rates, though it was still purchasing sovereign bonds in the secondary market.  Under Trichet's leadership, the tight monetary policy reinforced the fiscal austerity during a period of deleveraging.  The seeds of those decisions are still being harvested now.   

The ECB meets a day earlier than usual due to the Corpus Christi holiday.  The overwhelming majority of market participants does not expect the ECB to do anything, but perhaps build the case for additional accommodation later.  We have suggested that the market is under-estimating the risk of action by the ECB. 

At the heart of the mis-pricing seems to be two confusions.  The first is confusing Draghi with Trichet. Draghi did not wait when he first took office, as many expected.  He cut rates at his first two meetings.  He introduced the 3-year LTRO.  The market under-estimated his capability and creativity.  

The second confusion stems from putting the rate decision on the same continuum as the sovereign bond purchase program (SMP) and the LTRO.  The SMP and LTRO are about liquidity.  The refinance rate is about the economy.   The argument that the ECB will wait to see the results of the Greek election or the late June summit seem to mistake the potential need to liquidity provisions and monetary policy proper.  

News this week seems to lend more urgency to the need to lower rates, which the IMF has also urged. Many observers do not appreciate the severity of the economic data or the potential political and social consequences.  The composite PMI, which does a fairly good job of tracking GDP, is at two year lows.  The last time the service sector PMI was this low, Draghi was taking office and cutting rates.  

In addition, the most recent data, including the drop weakness in the PMI and industrial orders and warns that the German locomotive may be unable to prevent the euro area from contracting as it did in Q1.   Indeed, the German economy itself may contract in Q2.  

Moreover, the success German companies have had in penetrating Chinese markets (Germany accounts for around half of the euro area's exports to China) risks becoming a head wind as the world's second largest economy slows and more so than many expected, judging from recent cuts is GDP forecasts.  

Recent money supply figures were especially ominous.  The year-over-year growth in M3 slowed markedly to 2.5% in April from 3.1% in March.   Private sector lending fell in April by 87 bln euros, which was the third consecutive monthly decline. 

Inflation is moderating.  The euro area CPI peaked at 3% late last year and has been trending lower since.  The flash reading for may stands at 2.4%.  Although this is higher than desired, the economic weakness, fall in energy prices, and commodity prices more generally, provide compelling reasons to expect inflation pressures will continue to ebb.