He noted that credit constraints appear to be putting a brake on the recovery in stressed member states, adding to disinflationary pressures, which, if they become ingrained in disinflationary expectations, could cause households and firms to defer expenditure in a classic deflationary cycle.
President Draghi repeated that the ECB was not resigned to allowing inflation to remain too low for too long. He explained that the current spell of low inflation was mainly due to a fall in energy and food prices that occurred together with a stronger euro exchange rate. Moreover, relative price adjustments in stressed member states that are currently undergoing internal devaluations have dragged down aggregate euro area inflation as well.
Normally, temporary movements in the exchange rate, exogenous commodity prices or relative price adjustments would not warrant a monetary policy response. However, in certain circumstances they can morph into persistent shocks, especially if they destabilise inflation expectations, which would call for pre-emptive action.
President Draghi did not share his latest assessment on inflation expectations, but the ECB’s standard line that “medium- to long-term inflation expectations remain firmly anchored, in line with price stability” was plainly missing in his speech.
Another key message was that credit constraints appear to be putting a brake on the recovery in stressed countries, adding to disinflationary pressures. We have pointed out for some time the growing bank credit crunch in the periphery, which in our view also was apparent in continued weak lending volumes despite the much better loan demand revealed by the latest lending surveys. The latest ECB analysis showed that credit gaps caused by supply constraints may account for up to a third of the economic slack in stressed member states.
In the final part of his speech, “Calibrating the policy response”, President Draghi again signalled the Governing Council’s readiness to adopt a more expansionary monetary policy stance through a broad-based asset purchase programme (QE) if faced with a too-prolonged downward departure of inflation and/or inflation expectations from its current baseline projections.
Most of this section, however, was devoted to a discussion of targeted measures to help alleviate credit constraints. As in the past, President Draghi pointed to the development of capital markets as an alternative to bank credit supply and the ECB’s comprehensive assessment of bank balance sheets, which, while still ongoing, was already having a catalytic effect on asset revaluation, provisioning and capital raising.
However, he added that credit demand may pick up more quickly than these other trends gain traction, and in this context, if availability of term funding becomes a limiting factor on loan origination, monetary policy could play a bridging role.
We do not think that the ECB is about to launch a large-scale asset purchase programme (ie, QE) at this juncture, although some downward revision of its inflation forecast, especially for the near term, is likely in June.
Instead, we continue to believe that the ECB will probably announce a small cut in the refi rate, to 0.10%, together with a cut in the deposit rate, to -0.10%, at its next policy meeting on 5 June.
Moreover, we see today’s speech as another signal that these cuts could be accompanied by a targeted LTRO (at a fixed rate, targeted on SME lending) or a Funding for Lending Scheme (FLS) to address the mounting evidence of a credit crunch in stressed member states.