There is nothing stopping the ECB from cutting rates and easing monetary policy again soon – apart from a twist of Bundesbank recidivism and a short term show of political neutrality. With recession storm clouds gathering on the near horizon, Bundesbank resistance should give way soon . A little more discrete distance from the Italian elections should leave the ECB free to shift policy into an easier gear from as early as next month. With the German recovery now starting to show signs of fatigue, the Eurozone has lost its best champion for stronger growth ahead. The 3% January drop in German export orders was not a one-off as some suggested, but a signal that Eurozone economic conditions look set to become much more sour in the months ahead. By the time the first quarter Eurozone GDP numbers are published next month, the economy will have sunk even deeper into recession, after 5 successive quarterly output drops to date. The ECB monetary dials are pointing to extremely weak barometric pressure persisting for a long while ahead.
Certainly, the ECB discussed a rate cut at today’s meeting and Draghi confessed that policy is set to stay accommodative. It has to. The ECB forecasts expect greater downside risks to growth than before. Eurozone inflation is below target and set to go lower in the coming year. Credit conditions remain tight for consumers and the corporate sector. Monetary policy also needs to over-compensate for extremely restrictive fiscal settings in the Eurozone. Rising unemployment remains a key concern even for the ECB. The ECB can huff and puff about improving the transmission effect of monetary expansion getting through to beleaguered SMEs, but it is a side show. In reality, the banks’ payback of LTRO money (about 40%) is nothing to do with easing contagion jitters, but more to do with the banks wanting to slim down their balance sheets. If new credit growth is going to be the life-blood of the Eurozone recovery, the ECB still have to work out the best way to ensure the monetary transfusion is going to work. Maybe the ECB needs to disintermediate the banking sector as the delivery vehicle and apply direct mouth-to-mouth quantitative easing as the Fed, BOJ and BOE have done. The consequences can only be positive.
Lower rates, cheaper money and increased liquidity and credit will help all concerned. Lower borrowing costs will boost consumer and business confidence. Cheaper capital costs will boost confidence in the markets, lifting wealth effects in the process. Lower rates will help steepen the Eurozone yield curve. This will boost the banking sector’s natural franchise – borrowing short, lending long – improving profitability in the process. Easier ECB monetary policy will also help weaken the euro, boosting Eurozone export competitiveness at a stroke. If the ECB can see the vision, they should have the tools to get the Eurozone back into a virtuous circle of recovery. Perhaps they have a much better chance under Draghi’s pragmatism that they ever had under Trichet’s pro-Bundesbank conformism. And it is better if the moves are pro-active and pre-emptive rather than the same old reactive stable-door slamming. The Italian contagion stallion has not bolted yet, and better to beat it to the first fence while the current political gridlock holds in Rome.
The dollar should be the model for the euro as the ECB eventually relents. If the global Big Easy reflation coming through from the US, Japan, the Eurozone and UK starts to bubble up, the odds are that it will be the dollar that assumes the crown as the King-pin growth currency, as the euro abdicates its risk-on reign. If the currency markets start to chase the dollar on growth differentials, as happened around the turn of the millennium, the euro could see a sustained break below USD1.30, down towards the USD1.25-1.27 range. It will be capital flows on the hunt for better returns, deserting Europe for North American shores, that will be the swing producer fuelling dollar recovery ahead.
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