Thursday, November 3, 2011

A fundamentally more dovish ECB

I have to admit that I did not expect the ECB to cut rates already at today's meeting as I thought the governing council would not deviate from its script it has followed over the past 12 years.
So far the ECB has always set the repo rate for the average of the Eurozone, i.e depending on the outlook for inflation and growth for all of the Eurozone. Additionally, they never cut the repo rate when the nominal growth rate of the Eurozone was still so much above the repo rate as it is now. At the start of the cutting cycle in 2001, the spread between nominal growth (for the previous 12 months) and the repo rate was almost 0 and in 2008 it was negative. Currently, nominal growth is running significantly above the repo rate (+3% yoy up to June 2011). Even assuming zero real growth in both Q3 and Q4, nominal growth only drops to 2,1% by year end. Besides, the repo rate is currently already at low levels.

Nominal Growth vs. ECB Repo Rate: Spot the difference
Source: Bloomberg, ResearchAhead

However, while having been wrong with the repo rate cut forecast, I think it will facilitate the rebalancing process within the Eurozone. In those countries where the credit creation process/the monetary transmission mechanism is working (i.e. those without a sovereign debt/banking crisis), the lower repo rate will support domestic growth. The countries are in the North-Eastern part of the Eurozone, most notably Germany, and have been growing at a healthy rate already. The lower repo rate pressures real yields even lower from already historically low levels. With that it will support domestic investment and pressure the savings ratio lower. Furthermore, with wage pressures already building in Germany, inflation should also stay above 2% over the medium term. A stronger domestic German economy supports the overall Eurozone economy while a higher German price level renders it easier for the periphery to regain competitiveness.

Overall, the ECB seems to have moved towards a fundamentally more dovish interpretation of its mandate which threatens price stability in the "strong" Eurozone countries but at the same time helps to restore internal balance in the Eurozone. I stick to my long held multi-year bullish view on the German economy which has just received additional support.