ECB Moves, Mild Eurozone Fiscal Easing to Follow

Comments by policy-makers including ECB President Mario Draghi indicate that mild fiscal easing will follow as part of the policy response to the aftermath of eurozone crisis.

The ECB cut interest rates to record lows (including taking the bank deposit facility further into negative territory) and said a programme to buy asset-backed securities and covered bonds will begin in October. Draghi said the programme would have a "sizeable" impact on the central bank’s balance sheet and that purchases were "predominantly orientated towards credit easing".

Whether these and other measures, such as the targeted longer-term refinancing operations (TLTRO), will help the eurozone resume growth and avoid deflation remain to be seen.

Our base case forecast is for inflation to remain low, but for growth to gradually resume and deflation to be avoided. But deflation is a meaningful and rising risk. Inflation and core inflation have been well below target for some time - annual eurozone consumer price inflation dropped to 0.3% in August, from 0.4% in July.

The TLTROs and the completion of the ECB’s Comprehensive Assessment should improve lending conditions in 2015. However, bank appetite to lend and demand for credit may remain subdued regardless of the monetary conditions given weak growth and labour market conditions in much of the eurozone.

Draghi’s comments on the role fiscal policy can play alongside monetary policy in boosting growth are also notable. Flexibility within the fiscal rules could allow the eurozone "to better address the weak recovery and to make room for the cost of needed structural reforms," Draghi said at Jackson Hole last month. Some national governments have made explicit requests for relaxation of fiscal rules. These are politically controversial, but we think that eurozone policy is shifting towards mild fiscal easing, something underlined by Draghi’s comments.

This mild easing would continue the trend seen over the past two years, with the fiscal stance shifting from highly contractionary at the peak of the crisis in 2012, to roughly neutral in 2014. We expect that an agreement will be reached at the European level to slow the average pace of consolidation in the near term, but will attempt to stay within the letter of the rules. The authorities’ desire to maintain the credibility of the fiscal framework devised during the eurozone crisis makes a full-blown stimulus package unlikely at this stage.