Shah: On EM turmoil and ECB decisions
The most pressing policy question now facing the ECB at next week’s meeting is whether the current turmoil in EM is significant enough to warrant action, especially now that short-end money markets have normalised.
EM upheaval has become a more pressing issue, particularly on the inflation outlook. The possibility of further easing remains high and action could still come as early as next week.
Eurozone money markets at the short-end have now normalised, although the curve remains inverted. While the EONIA curve is now more normally sloped, we are still seeing elevated 3m Euribor fixings, highlighting that full normalisation has yet to be achieved. Volatility and higher Euribor could still see a response from the ECB given this is the benchmark that impacts corporate borrowers, while EONIA is dominated by banks.
But a more pressing issue has come on the radar, and that is the impact of EM turmoil on the eurozone growth and inflation outlook. It’s early days and things are still in a state of flux, but what is clear is that EM central banks moving policy from accommodative to neutral/tight will lower their growth outlooks.
While the direct impact of both Fed tapering and EM disorder on eurozone growth is likely to be limited, the picture changes for inflation: the prospect of slower EM growth and lower commodity prices could open the door to additional, unwelcome, disinflation. The latest data show eurozone inflation remains stubbornly low with headline inflation back to its October low of 0.7% y/y and core inflation at 0.8% y/y.
We now think the probability of a cut in the refi rate at next week’s meeting is low, but it is not zero. The March meeting, however, when the ECB delivers updated staff projections on growth and inflation, could prove a better time for more easing.
Measures that could be announced in addition to lower rates are
1) a cut in the reserve requirement rate to 0.5% or zero, and
2) officially shifting to a position of partially/fully leaving the SMP unsterilized.