ECB Rates: Still at Zero in 2020?

August 8 2018

The expectations on how exciting and informative the recent meeting of the board of the European Central Bank (ECB) on Thursday, July 26 would turn out to be were quite subdued. The last time the board of the central bank met, the market received some very important information, so this time it took somewhat of an effort and a lot of imagination to expect a repetition of the previous ECB board meeting. The odds that the central bank would adjust the June estimates regarding economic growth and inflation a mere month later, which would also put in doubt the earlier presented monetary course, were just as low as the official benchmark rate of the central bank.

For new revisions, we will have to wait until September. In September, the ECB computers will produce several revised estimates and forecasts. Add to that the fact that it is currently summer in the Eurozone (hence, vacations) and all the necessary ingredients are present for a decent-sized portion of nothingness from Frankfurt. And that is exactly what they gave us. Even the fact that annualized inflation in June reached 2 percent, and as a result is now slightly above the ECB target of “somewhat below, but close to 2 percent,” did not lead to any fireworks. The fact that a journalist asked a question about the differences between the English “through the summer” and its French translation – with the president seriously addressing the question – quite aptly showed how useless the ECB’s most recent meeting has been. If central bankers are talking about linguistic issues, then you probably have seen enough.

 

What I continue to deem crucial in the bigger picture, is that the ECB keeps repeating that inflation in the midterm will converge sustainably toward the earlier mentioned target, ifmonetary policy continues to be loose. This “if” is the real question, of course. The ECB is essentially admitting that inflation will not converge toward the bank’s explicit target ifmonetary policy becomes less expansive. Less expansive especially with regard to ECB rates, and not so much with regard to the central bank planning to end “quantitative easing” at the end of this year or at the beginning of next year. The fact that the ECB is ending such an extraordinary expansionary policy is quite logical, given the fact that deflation is no longer an imminent danger and the Eurozone economy is growing. Whenever I am referring to “loose” monetary policy, I am referring to the ECB’s main instrument, that is, interest rates. In other words, take the ECB’s promise that the official headline rate will remain at 0 percent at least until fall next year and will be raised very slowly, especially serious.

 

Add to this the fact that the threat of a trade war is still existent – in this light, the recent handshake between Juncker and Trump is good news, but as unexpected and surprising as the agreement initially was, any agreed upon truce can easily be broken and the trade conflict could heat up again – and it does not require a lot of fantasy to see that circumstances are favoring a scenario in which the ECB will keep rates at 0 percent for longer than the market is currently expecting, rather than a scenario in which the ECB will actually raise rates. The only thing that in this case is a certainty, is the fact that the ECB’s expectation that inflation will be sufficiently and structurally higher, is conditioned upon keeping monetary policy in the Eurozone extremely loose. Since some estimates show that the headline rate in the Eurozone should be at roughly 1.5 to 2 percent, whereas the ECB is talking about the necessity of keeping monetary policy (extremely) loose, I strongly suspect that we will see zero percent interest rates for the foreseeable future in the Eurozone. Only at zero percent interest rates, we could call monetary policy (extremely) expansionary. It would not surprise me if this would continue until the end of 2019. When the ECB subsequently begins to raise rates somewhere in 2020, I expect that in the most optimistic of scenarios we will see ECB rates below 1 percent far into 2021.

 

And then there is an elephant in the Eurozone room which the ECB is pretending to ignore. What am I referring to? The quite sizeable capital requirements (that is, maturing debt that must be refinanced) of various Eurozone countries in the coming year. The largest euro countries must refinance together between 2019 and 2021 a total of over €2 trillion euros. In the case of France, for instance, almost €199 billion must be refinanced in in 2019, followed by another €199 billion in 2020. Take note: this is exclusively the financing requirement to cover the expectedbudget deficits in those years (deficits could turn out to be higher). Italy must repay €282 billion euros in 2019, followed by another €234.5 billion in 2020 and €215 billion in 2021. For comparison sake: this year, Italy will be refinancing about €195 billion in public debt.

 

It needs little explanation that refinancing debt in the extraordinary circumstance of low ECB rates and other short-term interest rates is reasonably easy. If that were to change, then countries such as France and Italy (but certainly not exclusively these two) could easily find themselves in trouble. The ECB will never admit that rolling over public debt might play a role in the considerations that the central bank makes when it comes to its monetary policy, but from my conversations with (former) central banks, I know from firsthand that such considerations do play an important role.

 

Here it could actually backfire that euro countries have used years of “quantitative easing” and the enormous discounts in interest rates for anything butlowering structural budget deficits. A closer look at the data from Eurostat learns that all Eurozone governments together skimped 44.6 percent of GDP in 2006, but spent 46.1 percent of GDP. In 2017, government revenues equaled 46.2 percent of GDP and spending 47.1 percent. Hence, last year, both were higherthan in 2006. Not that higher interest rates will immediately result in a Greek-style debt crisis; some countries, such as Germany and the Netherlands, could easily cope with increasing interest rates on their debts. For other countries, however, the economic harm could gradually become worse. To such an extent that, if the ECB will indeed increase rates, these countries get sooner or later to a point at which the pain for Italy or France the debt will become unbearable (unless, of course, economic growth will begin picking up at an astonishing rate).

 

One of the consequences of all the above is that a notification from your bank that the interest rate on your savings account will be raised, remains quite unlikely. With regard to the odds of both an astonishingly higher economic growth in the Eurozone as well as the probability of higher ECB rates, I suspect that it is more likely that, before the end of 2018 andthe end of 2019, the ECB board will begin to conduct its meetings in German.

 

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