ECB is likely to stay put but it is a very close call

Despite the generally disappointing message of this week’s data, our baseline remains that the ECB will stay on hold at its May Governing Council meeting. Still, we believe it is a very close call, with further easing measures likely to be decided. If the ECB were to act, we believe further easing is more probable in June than in May.

A likely revision of the ECB’s inflation projection could trigger a further refinancing and deposit rate cut (c.10-15bp), as well as a cut to the MLF to limit Eonia volatility. However, we view the ECB as likely to save its last bullet on rates for now. Apparent supply-side constraints on bank credit could also push the ECB to decide on some targeted liquidity injections.

The ECB has recently put increased emphasis on the possibility of QE, notably at its last press conference. However, we think that the bar remains high for QE to be launched, and hence expectations by some market participants for QE are overplayed, in our view. This is notably related to the fact that effective QE implementation is far from straightforward.

Euro area “flash” April HICP rose 0.2pp to 0.7% y/y. The preliminary high-level breakdown was broadly in line with our expectations: core edged up by 3 tenths to 1.0% y/y, supported solely by services prices, most likely because of the timing of Easter. Downside surprises vs initial consensus expectations probably stemmed from food, alcohol, tobacco and/or non-energy industrial goods, which both fell (see Euro area inflation creeps up to 0.7% y/y, 30 April 2014).

More important than the slight downside surprise to consensus, the euro area “flash” April number is likely to be 0.3-0.4pp below the ECB expectations published in the March staff macro projection update. Combined with a likely c.0.15pp downside surprise in the March data, we see a significant likelihood that the ECB will have to lower its 2014 inflation profile by at least 0.1pp in the June update. We think 2015 and 2016 projections will also likely be lowered (Figure 1).

Stepping back from the most recent developments, we note that the ECB has been consistently over-estimating inflation for the last couple of years. This could argue in favour of: 1) the relative unreliability of the ECB’s forecasts; and 2) a possible regime shift since 2012 that the ECB’s models do not seem to capture well (Figure 2).

Including this week’s data, we revise down our euro area 2014 inflation projection to average 0.7% y/y (from 0.8% y/y previously). Still skewed to the downside, we now envisage risks to be less acute than previously. We maintain our 1.0% projection for 2015. At this horizon, we nonetheless continue to highlight material downside risks stemming from France and Italy as the pace of reform in those countries gathers momentum.

We see two main messages from the money, bank credit/survey data released this week. First, monetary aggregates and bank credit remain in the doldrums across countries and categories. M3 dropped 0.2pp to 1.1% y/y in March, while bank loans stayed at -2.0% y/y. Consumer credit has started to edge up, though annual growth remains largely in negative territory.

Second, the Q1 14 bank lending survey has showed that demand for bank loans has risen across the board during the economic recovery (Figure 3). Meanwhile, although credit standards eased for the first time since 2007, we find that banks nonetheless have kept them relatively tight (Figure 4).

We believe that credit supply remains weak and represents a downward risk to the recovery. And, if anything, these constraints are likely to persist until the results of the Asset Quality Review are published (end-October 2014).

Therefore, we believe that targeted ECB measures (notably longer-term refinancing operations aimed at encouraging bank lending to SMEs), which have been our base call for this year, are becoming more likely.