ECB Confronts Gathering Storm Clouds but Will Wait for Now, According to Reuters

By Balazs Koranyi and Francesco Canepa

FRANKFURT – The European Central Bank (ECB) is widely expected to maintain interest rates unchanged during its upcoming meeting, but it will need to confront a growing array of challenges that could jeopardize its attempts to stimulate growth and increase inflation.

Issues such as banking difficulties in Italy, the aftermath of Britain’s exit from the European Union, and a limited supply of bonds available for its asset purchase program may prompt the ECB to take action. This situation could thwart ECB President Mario Draghi’s hopes that the bank’s extraordinary stimulus measures were coming to an end.

Draghi, who is cautious about making abrupt moves, is anticipated to focus on verbal guidance, emphasizing the heightened risks and hinting at potential changes as early as September when new economic forecasts are unveiled. The aim will be to convey a dovish tone that indicates a readiness to act without making definitive commitments.

"Draghi will likely address market concerns regarding the ECB’s monetary policy by adopting a dovish stance and possibly suggesting further actions later this year," said Florian Hense, an economist at Berenberg. "For the ECB, it is crucial to keep options open."

The ECB is set to announce its rate decision at 1145 GMT, followed by Draghi’s news conference at 1230 GMT.

The euro saw a slight increase against the U.S. dollar, while futures on German government debt experienced a minor decline.

Currently, the ECB is engaged in purchasing €1.74 trillion worth of assets to lower borrowing costs, encourage spending, boost growth, and raise inflation, which has remained around zero for the past two years.

Brexit poses a significant challenge, as it may hinder a gradual recovery driven by investment and consumption. However, the ECB lacks sufficient data to make informed decisions. Early indicators like Germany’s ZEW sentiment index and eurozone consumer confidence surveys suggest a notable dip in sentiment, but these can be volatile, necessitating more extensive evidence for the ECB to respond.

While analysts have revised down their 2017 eurozone growth forecasts to 1.3 percent from 1.6 percent, inflation projections remain unchanged at 1.3 percent. This presents a mixed signal for the ECB, which aims for inflation just below 2 percent.

Draghi is likely to characterize Brexit as a political issue that calls for governmental action rather than central bank intervention—a perspective that may largely be ignored, much as his earlier pleas for structural reforms intended to bolster potential growth have been overlooked.

"Mr. Draghi’s calls for increased fiscal spending will likely go unheeded for the moment," noted BNP Paribas economist Luigi Speranza. "As it stands, the responsibility for addressing the Brexit fallout will fall to the ECB, which is acutely aware that its toolkit is becoming increasingly limited."

Constraints

With interest rates deeply negative and asset purchases at €80 billion per month, the ECB finds itself constrained, leading to higher barriers for any further action if it intends to preserve some capacity for future shocks.

Nonetheless, some policy adjustments are anticipated in the coming months, particularly as the ECB faces a dwindling pool of qualified assets to purchase, especially German government bonds, where yields have dipped below its -0.4 deposit rate—the limit it has set for its acquisitions.

The challenge will be whether to implement minor technical adjustments to its programs or to adopt more substantial and potentially contentious changes that could fundamentally alter the nature of its quantitative easing strategy.

"Technical issues can be addressed, but they highlight the limitations of relying solely on monetary policy, which Draghi is well aware of, thus his continuous calls for a more growth-supportive fiscal stance," said financial services group Nordea.

Analysts predict mostly technical changes for the foreseeable future, such as the potential purchase of bonds yielding less than the deposit rate and acquiring a larger proportion of bonds that lack collective action clauses.

More substantial adjustments may come later, especially since most analysts expect asset purchases to extend beyond their current expiration date next March, as technical modifications alone might not suffice to accommodate a significant extension.

Italian banks, burdened with approximately €360 billion in bad debts and declining share prices, are also likely to be a focus for Draghi. The Italian government is currently negotiating with the EU to secure state aid for struggling lenders while aiming to protect retail investors—a contentious proposal that could challenge EU bail-in rules.

While the ECB does not have direct authority over these matters, it retains a vested interest as the principal supervisor of the banking sector, which is the main conduit for its monetary policy.

The ECB has furthermore argued that European regulations permit state aid, citing provisions that allow for the protection of private investors from losses to maintain financial stability.