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PIMCO: How to Turn the ECB Straggler Into a Central Bank Pacemaker


Quicker bank deleverage could stimulate real economic growth.

Editor's note: This article by Myles Bradshaw originally appeared on PIMCO.

The U.S. Federal Reserve (Fed), Bank of Japan (BoJ) and Bank of England (BoE) have all been heavily engaged in asset purchases. The European Central Bank (ECB), in comparison, looks like a shrinking violet. As of 13 May 2013, the Fed's and BoJ's balance sheets have grown year-to-date by 14% and 10% respectively; the ECB's balance sheet actually fell by 14%.

How central banks use their balance sheet is also important: asset purchases are 10% of the ECB's balance sheet, but 97% of the Fed's. The ECB has provided funding support but, in contrast to the Fed, has transferred much less risk from investors' balance sheets. The result is that it has done less to help banks deleverage, improve their capital ratios and hence increase their willingness to lend.

Investors should be wary of extrapolating this status quo – Europe's weak economic outlook means that we should expect the ECB to become more, not less, engaged. The response is likely to remain fitful, switching from "Whatever It Takes" (WIT) to conditional support. We have already seen this with the ECB's Outright Monetary Transaction (OMT) program which was conceived as unlimited support to tackle "convertibility risk" but has been diluted to a conditional program as sovereign spreads have tightened.

Macro Outlook Suggest the ECB Will Need to Act On the Basis of "Price Stability"

The mid-point of the ECB's GDP forecast, -0.5% in 2013 and +1% in 2014, is in line with consensus. And this implies that the eurozone will return to trend growth toward the end of 2014.

The macro data suggests that more needs to be done to boost confidence to secure the forecast economic recovery. Figure 1 shows that, despite improving financial conditions in the eurozone, Banca D'Italia's EuroCoin estimate of GDP and the Markit Eurozone PMI survey remain consistent with recession in Q2 2013.

The ECB's own assessment is that growth will strengthen as exports grow and ECB monetary policy supports eurozone domestic demand. But it is difficult to see how monetary policy can work when the transmission mechanism remains broken. Figure 2, which shows the divergence in the cost of credit for eurozone small companies, reminds us that the eurozone policy response has still not fixed the monetary transmission mechanism.

Without much needed growth, the risk that inflation under-shoots the ECB's definition of its price stability mandate, "close to but below 2% inflation", rises. The eurozone's annual Consumer Price Index (CPI) fell from 1.7% to 1.2% in April 2013 (according to Eurostat). While some of this may reflect the timing of Easter, it is also worth noting that the ECB's own forecast is for low inflation: 2014 mid-point is 1.3%.

The macro data suggests that the ECB may now start to use its balance sheet more proactively to target growth and inflation. With that in mind, what might the ECB do next?

Further Rate Cuts are Highly Likely

European banks have been repaying ECB long-term refinancing operation (LTRO) borrowings at a €6.5 billion weekly pace since April 2013. At this rate, excess liquidity will be below €200 billion this October 2013 (see Figure 3), a level that in the past coincided with overnight money market rates beginning to move away from the ECB's 0% deposit rate and towards the ECB's 0.5% main refinancing rate.

A further interest rate cut therefore seems likely as we believe the economic outlook does not warrant an endogenous tightening in ECB monetary policy. But this is not an incremental monetary stimulus.

Fixing the Transmission Mechanism

Mr. Draghi has stated that the fragmented transmission mechanism started with the sovereign debt crisis. He has asserted that some of this fragmentation reflects issues beyond the ECB's control, specifically the lack of bank capital. But this is a weak argument for why the ECB should not address parts of the problem that reside within its realm of influence.
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