Investors warn the European Central Bank over monetary policy

By Zac Tate, Hottinger Investment Management

Investors are not impressed with Europe’s escape from near-recession. Traders have pushed down the Forward 5y5y Inflation Swap Index, a proxy for future expectations for inflation, towards 1% this week. This is the lowest level for inflation expectations since at least 2004 and reflects the rally in several European government bonds, including the sovereign paper of Italy and Greece.

The movement has, at best, shot to pieces the ECB’s hope that the market would take the reversal of QE and higher interest rates in its stride. At worst, it suggests that the ECB’s Governing Council may have to start thinking creatively about the next round of stimulus, starting from the unenviable position in which interest rates are already negative.

Figure 1 shows the Euro Area’s Forward 5y5y Inflation Swap Index. Technically, this shows the market’s expectations for the region’s 5-year average inflation rate starting in the next 5 years. However, investors often interpret this index as indicating the likely direction of inflation in the short term.

We have previously argued that Europe’s manufacturing sector has been at the heart of the region’s weakening economy as a slowing China and trade tensions weigh on global demand and exports. It appears that despite some good news in recent months, the European economy remains highly sensitive to global developments and this is what is causing concern among investors.

Last week, Germany’s Federal Statistics Office announced the biggest monthly fall in German industrial production in four years, with factory output in April 1.9% lower than it was in the previous month. Shortly after the German industry report, the Bundesbank issued its latest forecast for the economy, cutting its 2019 prediction from 1.6% to 0.6%.

According to Eurostat, during April eurozone industrial production shrank at a month-on-month pace of 0.5%, a greater rate than the consensus of -0.3%. Among the bloc’s other economies output was weaker in the Netherlands (-1.7%) and Italy (-0.7%) while in France (0.4%) and Spain (1.7%), it was higher. However, compared to a year ago, industrial output across the eurozone is 0.4% lower.

Export-facing categories of goods have fared particularly badly. Output of durable consumer goods was the weakest, shrinking by 1.7%, followed by a decline of 1.4% in the production of capital goods such as factory tools and machinery. With the euro area building up a large trade surplus to recover from the region’s extended financial crisis, there are renewed fears that weaker exports could infect the domestic economy and its services sector, which have so far shown a resilience supported by strong real wage growth and falling unemployment.

So what can the ECB do? In recent weeks, Mario Draghi has talked about targeted long-term refinancing operations or TLTROs. These are loans that the central bank offers to commercial banks at attractive rates on the condition that they use the resources to lend these funds on to the real economy. We have previously argued that TLTROs as currently designed are somewhat impotent. The implicit subsidy in the TLTRO lending rate of -0.4% is not large enough to incentivise big increases in lending to the kind of risky economic projects that generate growth. Chronically weak productivity growth and soft demand in the eurozone mean that banks struggle to find good ventures with an acceptable level of risk.

Eric Lonergan, a macro fund manager at M&G, has been promoting a novel tweak to TLTROs that would turn one of the central notions of banking on its head. The first principal of banking is that the bank charges a higher interest rate on its loans than it pays on its deposits, generating revenue on the spread between these two rates.  Central banks such as the ECB replicate this idea by setting their deposit rate below their borrowing (or refinancing rate).

Figure 2 shows the ECB Main Refinancing Rate (the rate at which the ECB lends resources to commercial banks) and the ECB Deposit Facility Rate (the rate at which the ECB pays for commercial banks’ deposits).

Lonergan’s suggestion is that central banks flip this order, lending to commercial banks at steeply negative rates and allowing them to deposit reserves at zero or positive rates. The ECB could introduce simple rules to prevent churning (i.e., redepositing borrowed funds) by requesting that, similar to the rules for TLTROs, any borrowed funds be on-lent to the real economy. Such an idea is radical and amounts to potentially a huge subsidy to commercial banks. If the ECB set a sharply positive deposit rate, the central bank would be subsidising consumers too if the ECB were to request commercial banks pass the returns to savers. Lonergan considers this as a ‘dual interest rate’ policy, where the central bank sets two interest rates and allowing them to diverge from one another at certain parts of the cycle. 

The idea is interesting but is not without its problems. Sharply negative rates potentially encourage speculative bubbles and by subsidising possibly unproductive projects they could lead to a waste of resources. However, such an idea could go far in re-establishing the ECB’s credibility at a time when inflation expectations are falling and the ECB’s Governing Council is flirting with the appointment of perma-hawk Jens Weidmann as its leader.

Conversely, a Weidmann ECB could ensure that Lonergan’s dual interest rates idea never gets off the ground. If so, the Eurozone could be more reliant on fiscal stimulus than ever before.