The debate among the members of the European Central Bank (ECB) council, who meet today to decide on the course of monetary policy, will likely be even more heated than within the FOMC. The hawks at the ECB will point to above-trend growth, a narrowing output gap, falling unemployment and a modestly positive credit cycle. The Economic Sentiment Index, an important leading indicator for the eurozone economy, notched up in February to its highest since September 2007.
Exhibit 1: Eurozone Economic Sentiment Index (ESI) and GDP % year-on-year (YoY)
Source: Datastream, BNP Paribas Investment Partners as of 6 March 2017
The unemployment rate was stable at 9.6% in January, but this is 2.5 percentage points below the 2013 peak. Bank lending to the private sector has accelerated, growing at 2.2% YoY in January. This may not look strong historically, but at least lending has turned from a drag on growth to mild support. In the bank credit segment, household consumer credit is growing at the fastest pace, followed by mortgages. Non-financial corporate loans are growing at only 0.5% YoY. The hawks would also point to the moral hazard of keeping interest rates too low. It could induce borrowers (both private and public) to postpone adjustments of any deficits and lead to excessive credit growth. This is a particular risk since private sector debt remains high across the eurozone.
The doves at the ECB have some ammunition left, especially regarding inflation.
Sure, eurozone headline inflation surged to 2.0% in February, but core inflation has held just at below 1% since last April. It could be that the output gap is still too wide to generate inflation. The doves could also point to the modest growth in bank lending. Private sector debt has not fallen by much, but has been basically stable since the financial crisis. Government debt has increased, though. And this is where things become tricky. If the ECB starts tapering its asset purchases, what would happen to ‘peripheral’ bond yields? Not much spread widening is needed in Italy to make it difficult for the country to stabilise its government debt-to-GDP ratio. But should the ECB leave quantitative easing intact in the whole eurozone just for Italy? This is not very likely, in our view. Even though an announcement of tapering by the ECB is widely expected later this year, bond yields have hardly reacted so far. Are financial markets ignoring this and has complacency crept in? Given the more balanced risks and the recent modest declines in yields, we are cautious about interest-rate risk in the eurozone and we are positioned underweight duration relative to our benchmarks.
We do not expect ECB president Draghi to take any steps now.
He could dip a toe into the water by upgrading the ECB’s balance of growth risks from biased to the downside to neutral. But even this may be a step too far. Raising the currently negative deposit rate slightly or an announcement of tapering at this point is even more unlikely, we think.
Written on 8 March 2017