What will it take for central banks to cut policy rates?

June 28, 2019 09:00
While acknowledging higher downside risks, the Swiss National Bank still expects global growth to stay around potential in the coming quarters. Photo: Reuters

Global growth has slowed in the second quarter, while inflation has not picked up as expected in most countries. While tight labor markets and elevated capacity utilization imply that wages and inflation could still rise in the coming quarters, data so far suggest that this should not worry central banks. In the case of the European Central Bank (ECB), the sharp fall in market measures of inflation expectations could trigger more stimuli. More broadly, central banks have the leeway to respond to the more difficult investment climate should trade tensions escalate further. We now see a significantly higher probability that monetary policy will become more expansionary in Europe.

Switzerland

At its quarterly meeting on 13 June the Swiss National Bank (SNB) clearly stated that it has further room to add policy stimuli either by lowering rates or expanding its balance sheet through forex interventions if needed. However, it also seems to be in no rush to do so. While acknowledging higher downside risks to growth originating from trade tensions and financial markets, the SNB still expects global growth to stay around potential in the coming quarters and the Swiss economy to maintain its solid dynamic. It also referred to high capacity utilization in the economy, which should eventually boost inflation. Absent a significant further deterioration of external demand and lower ECB policy rates, we expect the SNB to remain on hold for the time being.

Euro area

Inflation rates and expectations are clearly below target in the euro area and justify the support of low policy rates. Risks to growth are on the downside and relate to a number of factors such as increasing protectionism and trade tensions, the Brexit process and the political turbulences around the excessive EU Commission deficit procedure which could increase Italian risk premia further.

Yet the fragility and low profitability of the banking sector would be a hurdle for a rate cut and argue for a two-tiered system of deposit rates similar to the one in Switzerland. Effectively, this would imply lower marginal and negative deposit rates, while a significant part of the deposits that banks hold at the ECB would not be charged this additional levy.

Contrary to Switzerland, such a system is more difficult to justify as the main transmission channels of monetary policy are different and safe-haven FX flows play a more dominate role for the Swiss Franc. Hence, lower Swiss rates help to prevent a stronger exchange rate and directly address the effects of the potential weakness of the external outlook. Given the larger size of the euro area economy, domestic financial conditions are more important. They are already favorable. As a consequence, we expect the hurdle for a rate cut to be quite high but could imagine a cut by September if trade tensions do not abate and spill over into the domestic economy.

The ECB has also opened the door to additional quantitative easing. While this is possible, it is not clear whether it would provide much support to the economy. Bond yields are already at historical lows. Moreover, the ECB hasn’t been very clear on how it views the 33 percent issue ceiling on government bonds, a material limit to expanding QE. Changing the ceiling is likely to be politically contentious. The ECB could buy additional risk assets, but it would face the same hurdle.

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RC

Chief Economist, Head Economic Research at Bank J Safra Sarasin