Mario Draghi admits that the European Central Bank’s options are limited

The hope generated by last month’s ECB press conference have been largely disappointed.

In May’s press conference, Mario Draghi created several expectations:

1. Further refi rate cut: “we will stand ready to act if needed”

2. The deposit rate, currently at 0%, could be brought negative: “we are technically ready”

3. Joint measures could be taken with the European Investment Bank (EIB) to revive the ABS market in order to reduce euro area fragmentation and improve financial conditions in the periphery notably for SMEs.

ABS for SME loans revival unlikely in the short-term
Mario Draghi was very vague on the third point yesterday. He said that a solution might result from the work of the task force set up with the European Investment Bank, but these were solutions for the medium to long-term.

Unchanged monetary policy, lower GDP growth forecast
During the press conference, Mario Draghi announced that the ECB’s key interest rates will be left unchanged. As a result, the refi rate remains at 0.5%, the deposit rate at 0% and, the marginal lending facility rate at 1.0%.

ECB-07.06.2013-1

At the same time, the 2013 GDP growth forecasts have been revised down, from -0.5% to -0.6%. 2014 projections have been revised up from 1.0% to 1.1%. The inflation projections for 2013 have revised down (from 1.6% to 1.4%).

Negative deposit interest rates unlikely
On the second point mentioned above, the ECB will probably never fix negative deposit interest rates. The side effects of such a measure would outweigh the intended benefits. Moreover, it is quite a radical non-orthodox decision and the Governing Council has shown in the past how difficult it was to achieve a consensus on non-standard measures.

Federal elections in Germany stand in the way of any bold decisions
The fact is that every bold decision to solve the European crisis currently depends on the October’s Federal elections campaign in Germany. In spite of Angela Merkel’s very high popularity, the renewal of the current coalition is at stake due to very low vote intentions for the FDP, the junior party in the coalition. The Chancellor is therefore unable to make concessions in matters that are very touchy with its conservative electorate.

Banking Union delayed by German elections
Progress towards banking union provide a clear illustration of the situation. Despite the European Commission and the ECB insisting on the need for a rapid implementation of a single resolution mechanism (SRM), the German government opposes a solution where resolution will remain in national hands.

ECB left with little room of manoeuvre
The German electoral agenda is also likely to prevent the ECB from adopting any bold measures. As a result, the ECB’s room of manoeuvre is limited to a last 25 bp refi rate cut and some relaxation in collateral acceptation rules. In any case, no move that would constitute a significant move towards reducing the gap in financial conditions between core and periphery countries is on the cards.

ECB-07.06.2013-2

Sluggish economic activity
All in all, the euro area continues to face a very gloomy situation. Although recent surveys showed an improvement for euro area periphery countries in April and May, it is far from clear if these economies will be able to engage in a proper economic recovery. A softening of the contraction towards close to zero GDP growth is more likely at this point. Intermediate economies, such as France, Netherlands and Finland, are back in recession. Meanwhile, Germany’s exports and industrial activity are weak owing to subdued global demand.

A poisonous cocktail
Disappointing economic activity combined with rising public debt and gridlocked decision-making process are likely to create a poisonous cocktail. As a consequence, the recent optimism on financial markets may well prove to be based on a discounting of too much good news and this is likely to be the recipe for a harsh return to reality.

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