Eurozone: ECB aims to combat low inflation with launch of ABS and covered bond purchases
September 29, 2014
The European Central Bank (ECB) announced further radical measures to spur credit growth, fight low inflation and prop up the Eurozone economy at its most recent meeting that took place on 4 September. The ECB cut the main refinancing rate by 10 basis points to 0.05%, which marks a new record low for the region’s policy rate. Moreover, the ECB cut the deposit rate—the rate banks receive for parking funds at the ECB—from minus 0.10% to minus 0.20%, moving this key rate even further into negative territory. The ECB also cut the marginal lending rate by 10 basis points to the current 0.30%. Market analysts had not expected the Bank to make these decisions.
In addition, the ECB launched a plan to conduct large-scale purchases of asset-backed securities (ABS). ABS are essentially pools of different loans which private banks sell to investors in order to make their balance sheets lighter and to be able to issue new credit. These securities are sold in tranches according to the varying risk of the underlying loans. Draghi said that the ECB will only buy safe ABS tranches—the so-called “senior tranches”—and that it will only buy risky tranches—the so-called “mezzanine”—only if there is a guarantee. As the ECB emphasized in its monetary policy statement, the decision to launch a program of ABS purchases, “reflects the role of the ABS market in facilitating new credit flows to the economy.” In parallel to ABS purchases, the ECB will launch a plan to purchase euro-denominated covered bonds—corporate bonds that are “secured” by a set of assets should the issuer become insolvent. Details on the program—in particular on the size of the purchases—will be revealed at the next ECB meeting set for 2 October.
Markets had speculated about, and had partly anticipated, the ECB’s course of action ever since President Draghi's speech at the late-August Jackson Hole meeting at which the he emphasized a downward shift in market gauges of inflation expectations. According to Draghi’s prior statements, a deterioration in the mid-term inflation outlook would have provided justification for the ECB to launch an asset purchase program. This view was partially corroborated by the ECB staff’s new annual inflation forecast for 2014, which was revised down to 0.6% from the 0.7% that was expected in June. However, projections for next year and 2016 were left unchanged compared to June (1.1% and 1.6% respectively).
Moreover, the importance of anchoring inflation expectations in justifying the asset purchase program was highlighted in the ECB’s monetary policy statement. According to the ECB, the decisions were taken, “with a view to underpinning the firm anchoring of medium to long-term inflation expectations, in line with our aim of maintaining inflation rates below, but close to, 2%.” A subdued outlook for the economic recovery was also a reason for providing further monetary easing. The ECB staff also revised their forecasts for GDP growth downward and currently expect the Euro area economy to grow 0.9% in 2014 (June forecast: 1.0%) and 1.6% in 2015 (June forecast: 1.7%). That said, the 2016 GDP growth forecast was revised up from 1.8% to 1.9%. However, according to the ECB, risks to the growth outlook continue to be on the downside.
Market analysts’ reaction to the ECB decision has been mixed and there is still skepticism regarding whether the new measures will succeed in propping up inflation and revitalizing the Euro area economy. That said, the ECB stated that, “[s]hould it become necessary to further address risks of too prolonged a period of low inflation, the Governing Council is unanimous in its commitment to using additional unconventional instruments within its mandate.” This wording clearly leaves the door open for further action in the coming months.
Author: Armando Ciccarelli, Head of Data Solutions