ECB, Less Accommodative Monetary Policy Stance

The eurozone exited from the recession in the second quarter of 2013, with GDP switching back to positive growth after continuously falling over the previous 6 quarters. Several factors suggest that the recovery might have relatively solid foot. Domestic demand is finally recovering, benefiting from the past improvements in financial markets and from a moderation of fiscal tightening. Yet, it is too early to claim victory. The recovery remains fragile, uneven and its pace anaemic, as the recent decrease of leading indicators remind us. The recovery needs to be strengthened. As the process of consolidating public finances constrains fiscal policies, the eurozone has no alternative but to rely on the monetary policy to support the recovery.

Monetary policy stance...still very-accommodative? The ECB has undertaken several measures to offset the effects of the crisis. In particular the OMT has been a success in reducing tensions, easing financing conditions and eradicating the perceived risk of reversibility of the euro. Yet, several factors are making the monetary policy stance less accommodative. Last week we dealt with reduction of excess liquidity and its impact on the monetary policy stance1. This week we focus on the recent euro appreciation and its consequences for the ECB monetary policy.

The EUR/USD has recently broken the threshold of 1.38, the highest level in two years. Since its cyclical trough of August 2012, it rose by 10%. It is worth stressing that the euro is appreciating against all major currencies. Since August 2012 it gained 40% against the Yen, more than 22% against the Australian dollar, almost 17% against the Canadian dollar and more than 7% against the UK pound. Over the same period the nominal effective exchange rate (NEER), which measures the strength of the euro against a basket of currencies, rose by around 8%. Several factors drive the exchange rate movements. Growth prospects are undoubtedly one of them. This dimension, however, should play against the euro.

Prospects are much more buoyant among the other advanced economies than in the eurozone, where deleveraging process, high unemployment rates and credit market fragmentations weigh on activity. Financial tensions are another key dimension of the exchange rate. The reduction of financial market tensions following the launch of the OMT favoured, undoubtedly, an appreciation of the euro. In addition, the political gridlock in the United States concerning the continuing resolution and the debt ceiling, decreased the US dollar. Last but not least, the orientation of the monetary policy is another force behind exchange rate movements. On this front, other major central banks have been following much more aggressive accommodative monetary policies than the ECB. The Fed is still conducting an ultraloose monetary policy and we do not expect the Fed to scale it down before the end of Q1 2014. The Bank of Japan has seen its balance sheet increasing sharply since Mr Abe launched its strategy to raise inflation up to 2% within 2 years. By contrast, the ECB balance sheet has been decreasing since mid-2012 (footnote 1 for details).

Note: The FMCI used is a weighted average of real effective exchange rates (y/y), equity prices (y/y), money supply growth, real corporate bonds, the TED spread, yield curve, real policy rate (deflated by core inflation), real short and long rates, real retail rates and credit growth. The weights are proportionally inversed to the volatility of each component. The index is standardized so that the mean is equal to zero and the standard deviation is equal to 1. Above 1 means tighter conditions.

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A protracted rise in the exchange rate might derail the already fragile recovery. Renew tensions in financial markets following the May announcement of a possible tapering of QE3 by the Fed and the euro appreciation are making financial and monetary conditions less accommodative. As shown in the chart, activity has recently stabilised but the recovery needs a boost.

A protracted appreciation of the euro might have consequences for inflation and growth within the zone. A standard Vector Autoregressive analysis suggests that a 10% increase of the NEER, reduces inflation in the range of 0.4-0.6 pp after one year. Currently the ECB is projecting inflation at 1.3% next year. Yet these projections were conducted assuming the EUR/USD at 1.33 in 2014. Should the euro continue to appreciate or stabilise at current levels, inflation projections should be revised downwards. The ECB would risk missing by a significant amount its target for price stability. In this case an action (a refi rate cut?) would be necessary.

However, we do not expect a move as soon as next week ECB meeting. While within the Governing Council some members would favour a cut in the policy rates (at least the refi rate) a majority of members (or at least an influent minority) is still reluctant. It is worth stressing that member countries have different sensitivity to exchange rate movements. For instance, Germany seems more immune to exchange rate movements than its peers; its export competitiveness is based more on quality than on price of its products. By contrasts, some peripheral countries are much more exposed to the appreciation of the currency. This might create further difficulties to find a large and influent majority within the council to support a cut.

BY Clemente DE LUCIA

Written By: BNP Paribas