ECB Rate Cut Is Weapon of Choice as Draghi Threatens Action

(Bloomberg) -- European Central Bank policy makers anticipate using an interest-rate cut as their first stimulus move if they need to act again to boost inflation, according to three euro-zone central bank officials.

Lowering borrowing costs further below zero would be the most likely initial step rather than resuming asset purchases, said the officials, whose alarm at the descent of market inflation expectations to a record low is nudging them all toward favoring action. They didn’t want to be identified, citing the confidentiality of such discussions. An ECB spokesman declined to comment.

ECB President Mario Draghi appeared to set a low bar for action on Tuesday when he said additional stimulus will be needed “in the absence of any improvement” to the outlook for growth and inflation. He specifically cited rate reductions as an option, sending the euro lower and prompting money markets to price in a 10 basis-point cut by December.

Investors subsequently brought forward their expectations to September after Bloomberg’s report. Commerzbank now predicts such a policy step in July.

“Draghi is going to finish his tenure with a cut,” said Claus Vistesen, chief euro-zone economist at Pantheon Macroeconomics. “The door is now open and I don’t see how they can not walk through it.”

An ECB rate reduction could stoke trade tensions with U.S. President Donald Trump’s administration. He tweeted on Tuesday that ECB action that weakens the euro is unfair.

Draghi, who spoke at the ECB’s annual forum in Sintra, Portugal, also said the institution could resume quantitative easing, even if it needs to raise self-imposed limits to do so. While those rules were put in place to avoid crushing markets and crossing the line between monetary and fiscal policy, he said they are “specific to the contingencies we face.”

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“Draghi seems to be notching up his dovish tone. Today he hinted that the Governing Council may be willing to tolerate inflation running above the ECB’s goal to compensate for the recent, protracted period of below target price gains...Achieving this objective could involve further interest rate cuts or restarting the asset purchase program.”

--David Powell and Maeva Cousin
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The ECB is grappling with an economic slowdown and an inflation rate that remains entrenched below its goal. Draghi said risks from geopolitical factors, protectionism and vulnerabilities in emerging markets haven’t dissipated and are weighing in particular on manufacturing.

That sentiment is being felt at major central banks around the world, which are moving back into battle mode. The U.S. Federal Reserve, Bank of England and Bank of Japan all hold policy meetings this week, which should give further insight into their concerns. Investors are betting on U.S. interest rate cuts later this year, while central banks in Australia, Russia, India and Chile have already loosened policy.

The ECB Governing Council looked at stimulus possibilities at its June 6 decision, though stopped short of determining a need for immediate action. Draghi’s mention then of the option of more QE left his former adviser, Arnaud Mares, now an economist at Citigroup, with the impression that the ECB would use that tool first rather than rate cuts.

One concern over further rate cuts is that it might squeeze banks’ profitability to the point where they pare back lending to companies and households. They’ve complained that they can’t easily pass on the negative deposit rate onto their depositors.

On Tuesday, Draghi also referred to possible need for “mitigating measures” to soften the effect of the ECB’s negative rate, currently at minus 0.4%.

While one ECB official said a tiering system that exempts some banks’ deposits from the sub-zero penalty would almost certainly be required in the event of further cuts, that could be a sticking point. Another of the officials said there’s no need for tiering and a decision on that could at least be put off until later.

The officials were open on the timing of any move. A Federal Reserve interest-rate cut could become a trigger if a narrower difference between U.S. and euro-area policy rates threatened to boost the euro, two of them said. The exchange rate isn’t a policy target for the ECB, but the officials noted that it can have a significant impact on inflation and growth.

ECB staff see inflation reaching only 1.6% in 2021, compared with a goal of just under 2%, and Draghi will leave office this October as the only ECB president never to have raised interest rates.

“If the crisis has shown anything, it is that we will use all the flexibility within our mandate to fulfill our mandate,” Draghi said Tuesday. “And we will do so again to answer any challenges to price stability in the future.”

--With assistance from Catherine Bosley and Joao Lima.

To contact the reporters on this story: Paul Gordon in Sintra, Portugal at pgordon6@bloomberg.net;Piotr Skolimowski in Sintra, Portugal at pskolimowski@bloomberg.net

To contact the editors responsible for this story: Craig Stirling at cstirling1@bloomberg.net, Fergal O'Brien

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