FMR_SPECIAL_REPORT_2014-036_12-03-2014_GB

What changes would be needed for the ECB to cut its rates further? According to our reaction function, three factors - or a combination of them - could lead to a cut in monetary policy rates in the euro zone: a rise in the unempl oyment rate of around 0.3 percentage point; an appr eciation of the euro of roughly 10 cents; no rebound in head line inflation in April, contrary to what is expect ed. While the probability associated with these developments is not insignificant, which justifies the downward bias in the ECB's monetary policy stance, we continue to be lieve the most likely scenario for key interest rat es is status quo. Despite the decision this month to leave interest rates unchanged, the ECB has maintained its forward guidance, leaving the door ajar for another round of conventional easing. But while markets on the whole were surprised by the status quo this month (Chart 1 ), we seek to determine what developments would be needed to convince the ECB to cut its rates again.

We make the assumption that there will be no external shock to the European economy (currency crisis in emerging countries, geopolitical crisis in Ukraine, extreme weather events, etc.). A rate cut could then be triggered by short-term changes in the economic variables that have the greatest impact on the ECB’s monetary policy actions. In our opinion, they include inflation, the unemployment rate (its deviation from the natural unemployment rate, the threshold from which wages - and therefore underlying inflation - accelerate), the euro's exchange rate and, to a lesser extent, changes in the M3 money supply.

We have actually shown in the past that these variables are part of the ECB’s historical reaction function, which resembles a Taylor Rule adjusted for certain financial conditions1. These variables do not all have the same importance, and the impact of some of them is lagged, e.g. the exchange rate and the money supply:

( ) ( ) ( )

( ) ( )sept_dummy*.M*.EUR*.

Infl*.gap_NAIRU*..ECB

.t

.t

.

t.

t..

t

113303080431

23087014

749

086

212

105934226

−−−

−

−

−+

−++=

Starting from our estimate of the ECB's repo rate by using this reaction function, while taking into account the data available for the March Council meeting, we simulate the short-term changes that would drive the repo rate significantly below the current level of 0.25% (Chart 2 ).

1 Flash 2006-289: “Do you speak ECB?”

99,64

99,66

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99,70

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99,74

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99,78

99,64

99,66

99,68

99,7

99,72

99,74

99,76

99,78

02 January 2014 01 February 2014 03 March 2014

Chart 1Euribor 3M September 2014

Sources : Reuters

ECB Council

Meeting 6 March

12 March 2014 - No. 36

Sylvain Broyer, Cédric Thellier

N° 36 I 2

Ceteris paribus, and based on our working assumptions, we find that the ECB might cut its repo rate if:

• The unemployment rate rises by around 0.3 percentage point (without the structural unemployment rate changing significantly);

• The euro appreciates suddenly but lastingly by roughly 10 cents against the dollar;

• Inflation does not rebound by 30 bp in April, contrary to what is expected (due to a base effect, Chart 3 );

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00 01 02 03 04 05 06 07 08 09 10 11 12 13 14

Chart 2ECB Repo rate & augmented Taylor rule

ECB key rate

Fitted reaction function

Sources: ECB, NATIXIS

Fore.

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0

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0

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Chart 3. Euro zone: HICP inflation rates(YoY as %)

Headline HICP

Core HICP

Sources: Eurostat, Natixis

Fore.

N° 36 I 3