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 unemployment rate of around 0.3 percentage point; an appreciation
of the euro of roughly 10 cents; no rebound in headline inflation in April, contrary to what is expected. 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 believe the most likely scenario for key interest rates 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 ECBs 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 ECBs historical reaction function, which
resembles a Taylor Rule adjusted for certain financial
conditions
1
.

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
11 33 0 3 08 0 43 1
23 0 87 0 1 4
7 4
9
0 8
6
2 12
1
0 5 9 34 2 26

+
+ + =


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
99,68
99,70
99,72
99,74
99,76
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 1
Euribor 3M September 2014
Sources : Reuters
ECB Council
Meeting 6 March
12 March 2014 - No. 36

Sylvain Broyer, Cdric Thellier

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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);







































0,0
0,5
1,0
1,5
2,0
2,5
3,0
3,5
4,0
4,5
5,0
0,0
0,5
1,0
1,5
2,0
2,5
3,0
3,5
4,0
4,5
5,0
00 01 02 03 04 05 06 07 08 09 10 11 12 13 14
Chart 2
ECB Repo rate & augmented Taylor rule
ECB key rate
Fitted reaction function
Sources: ECB, NATIXIS
Fore.
-1
0
1
2
3
4
-1
0
1
2
3
4
02 03 04 05 06 07 08 09 10 11 12 13 14 15
Chart 3. Euro zone: HICP inflation rates
(YoY as %)
Headline HICP
Core HICP
Sources: Eurostat, Natixis
Fore.

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3