Central Banks Struggle With Policy Settings

Central Banks Struggle With Policy Settings


FRANKFURT—Theeurozone’s economic slowdownhas taken European Central Bank officials by surprise, potentially disrupting their plans to lift short-terminterest ratesthis year.

The shift underlines the difficulties central banks face getting back to growth rates and policy settings that were considered normal before the global financial crisis.

In June, the ECB appeared to be on course to end its bond-buying stimulus program at the end of 2018 and follow that with a first rise in its key interest rate some time this year. Right now, it charges banks 0.4% to deposit money with the central bank, a negative interest rate.

So widespread was the expectation of the first rate rise since 2011 that policy makers issued a statement promising not to move at least through the summer of 2019 to calm worries it might move too soon.

Since then, disappointing data have made it clear that the eurozone economy is weaker than the ECB expected. The ECB’s economists have cut their growth forecasts in each of their last three reports on the economic outlook.

Now, many investors expect the ECB to do nothing until next year. Some are considering what the bank could do to stimulate the 19-nation eurozone economy if it sinks.

“The narrow window in which the ECB could have lifted its key interest rate from emergency, negative levels, has closed,” said Simon Wells, an economist with

HSBC

in London. He expects the ECB to hold its deposit rate at current levels through at least the end of 2020, having previously forecast a first 0.15 percentage-point ECB rate increase for September.

The ECB outlook reflects a global shift in central banking. Federal Reserve officials—unsettled by market turbulence and slowing global growth—have said they would be patient before moving rates up again, meaning they’ll pause after a series of rate increases last year and before.

The Bank of Canada has also made a notable about-face. In early December, the Canadian central bank pointed to a weaker-than-anticipated housing market and the rapiddecline in oil pricesin signaling apause in rate rises.

“We have to do our work in order to understand the shock better and what its magnitude actually is,“ Governor Stephen Poloz said last month. “We need some time.”

ECB President Mario Draghi is expected to acknowledge the darkening outlook after the bank’s policy meeting Thursday. Speaking at the European Parliament in Strasbourg earlier this month, Mr. Draghi admitted that recent data had been weaker than expected, although he argued that the eurozone probably would avoid recession.

“At least for some time to come, there’s going to be a continuing uncertainty that changes nature, and this has a cost. And the cost is lower confidence—lower business confidence and lower consumer confidence,” Mr. Draghi said.

JP Morgan

projects a first rate rise in December, rather than September, and sees fewer subsequent moves.

The eurozone economy enjoyed its fastest growth in a decade during 2017, a 2.4% expansion that ECB’s economists expected to see continue through 2018. The World Bank now estimates growth slowed to 1.9% last year and will slip further to 1.6% this year.

Much of the turnaround is due to weaker demand for eurozone exports. There are problems closer to home as well. Holdups at Germany’s key automobile factories pushed Europe’s largest economy to the brink of recession in the final six months of last year. Italy may not have avoided that fate, following a jump in borrowing costs as investors fretted over the government’s plans to add to an already large debt load.

In France, President Emmanuel Macron is wrestling with rolling mass protests aimed at derailing his economic reform plans. And the U.K.’s Parliament is deeply divided over how to manage the country’s planned divorce from the European Union, barely two months before it is due to depart.

The composite Purchasing Managers Index for the region—which measures manufacturing and services activity—fell to its lowest level in more than four years in December.

The firm that compiles that measure—

IHS Markit

—has built a model that assesses the probability of a policy move based on the past relationship between the indicator and policy changes: it suggests the probability of a rate rise is just 7.7%, and a rate cut is more likely.

Europe’s economic prospects could brighten. A trade deal between the U.S. and China could revive growth, and a smooth Brexit would help. Unemployment has fallen below 8%, its lowest level in more than a decade, and wages are rising relatively briskly.

However, that hasn’t yet triggered a sustainable rise in inflation toward the ECB’s target of just below 2%. Figures released Thursday show the core inflation rate—which excludes volatile prices such as those charged for energy and food—was unchanged at 1% in December.

ECB officials are mindful of the bank’s past tendency to raise interest rates at the wrong time. It increased key rates in 2008 and then again in 2011. In both cases those moves were followed by recession.

If Europe is indeed headed toward a new downturn, policy makers would be in an uncomfortable position. The ECB has little room to cut interest rates further or to buy more government bonds.

“The uncomfortable truth is that there may not be a whole lot the ECB can do to offset a moderate slowdown,” said Mr. Wells.

Write toTom Fairless at[email protected]and Paul Hannon at[email protected]

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