ECB in Wait and See Mode

Anthony Doyle, Investment Director, Retail Fixed Interest, M&G Investments

It appears that the European Central Bank, like the Bank of England, is currently in wait and see mode to assess the impact of the UK’s decision to leave the EU. The Eurozone economy has been experiencing a slow but steady growth recovery over the past couple of years but looking further ahead there appears to be some significant downside risks to this growth momentum.

Anthony Doyle
The uncertainty around Brexit will certainly act as a drag on growth for Europe, as will rising oil prices and heightened geopolitical risks. In addition, the ECB will be closely watching bank credit growth to determine whether stresses in the banking sector are having a negative impact on lending activity.

With European inflation likely to remain low for the remainder of the year and next, we expect that the ECB to make further announcements in September regarding a possible time extension of its asset purchase programme (APP) as well as changes to the programme parameters (including removing the yield floor, reviewing the capital key, raising the 33% issue share limit and buying debt with a maturity of longer than 30 years). This will enable the ECB to ensure that there are sufficient eligible securities for the APP, as the universe of what the APP can buy is quickly diminishing due to the collapse in government bond yields to levels close to or below the ECB deposit rate of -0.4%. A cut in the deposit rate is unlikely given the impact that negative rates can have on bank profitability and an already stressed financial sector.

Institutions such as the OECD and IMF have argued that countries within the Eurozone should contribute to improving the growth outlook through looser fiscal policy. Germany is arguably best placed to embark on fiscal loosening from a budgetary standpoint and higher German public investment would not only stimulate domestic demand in the near term, but would also raise domestic output over the longer-run and generate beneficial spillovers across the euro area. However, Germany already benefits from ultra-loose monetary policy and a weak currency, meaning any stimulatory fiscal stance is unlikely.

Additionally, there is a fear within Germany that they will end up indefinitely subsidising the whole European periphery. If Germany ramped up public investment and started running deficits now, it would have no (moral) authority to make any demands on peripheral countries to keep budgetary discipline. The type of coordinated effort that Europe needs – a combination of stimulatory fiscal and monetary policy – appears out of reach. Without the coordinated effort of policymakers, it is difficult to see how the Eurozone will generate higher living standards over the longer term for its 340 million inhabitants.