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ECB readies package of rate cuts and targeted measures

An illustration picture shows Euro coins, photographed in Warngau April 3, 2013. REUTERS/Michael Dalder
An illustration picture shows Euro coins, photographed in Warngau April 3, 2013. REUTERS/Michael Dalder

By Andreas Framke, Paul Carrel and John O'Donnell

FRANKFURT (Reuters) - The European Central Bank is preparing a package of policy options for its June meeting, including cuts in all its interest rates and targeted measures aimed at boosting lending to small- and mid-sized firms (SMEs).

Five people familiar with the measures being prepared detailed plans involving a potential rate cut, including the ECB's deposit rate going negative for the first time, along with the targeted measures SME measures.

The package offers some stimulus for the euro zone economy but falls short of the large-scale effect the ECB could unleash with a major program of quantitative easing (QE) - money printing to buy assets. Such a QE plan is still some way off.

A June rate cut is "more or less a done deal", said one of the five sources who spoke to Reuters on condition of anonymity.

A second source echoed that sentiment, and added: "This will be the first major central bank to move to a negative deposit rate. That would move the exchange rate."

ECB Executive Board member Peter Praet also told German weekly newspaper Die Zeit the central bank could cut its deposit rate into negative territory as part of a package of policy measures that could also include a targeted long-term refinancing operation (LTRO).

The latter is a method of boosting bank liquidity in the euro zone with an eye to increasing lending.

The first two sources spoke to Reuters of a cut of 10-20 basis points, probably in all three ECB rates. The main refinancing rate is currently at 0.25 percent.

Both sources expected the move to bring down the currency exchange rate but said the ECB had made no calculation of how much it was likely to fall by, and had no target for the euro.

The ECB declined to comment when asked about the plans.

ECB President Mario Draghi said last week the Governing Council was "comfortable with acting next time" - its June 5 policy meeting - but wanted to see updated economic projections from the bank's staff first.

"Negative deposit rates are a possible part of a combination of measures," Praet told Die Zeit. "We are preparing a range of things. We could again lend banks money for a longer time frame, possibly with conditions attached."

Praet did not see the ECB embarking on U.S.-style QE unless economic conditions deteriorated: "I think it will only come to that if the euro zone economy and inflation develop significantly worse than we expect," he said.

DANGER ZONE

The ECB's deposit rate already stands at zero and a cut into negative territory would see it essentially charge banks for holding their money overnight - a move that could spur more lending, though analysts are unsure how banks would react.

The ECB is concerned by the euro's strength and low inflation, which Draghi is worried could get stuck in what he calls a "danger zone" below 1 percent. At 0.7 percent, inflation is running well below the ECB's target of just under 2 percent.

Andrew Bosomworth, a senior portfolio manager at bond fund Pimco in Munich, said a cut in all three ECB interest rates and a new LTRO would be a light cocktail, like a "Campari Orange".

"If you only cut rates and introduce an LTRO - yes, it'll have an impact but it won't be as strong as, for example, (also) pushing out the fixed-rate full allotment another six to 12 months and abolishing the SMP drain," Bosomworth added.

The ECB's fixed-rate full allotment procedure sees it lend banks as much cash as they want at a fixed interest rate at its regular refinancing operations. With the SMP sterilizations, the ECB seeks to offset its past purchases of government bonds made under its Securities Markets Programme (SMP).

Extending the fixed-rate full allotment would extend the timeframe over which the ECB lends banks as much money as they want at a fixed rate, and ending the SMP sterilization would release billions of euros into the market.

All four measures together - rate cut, LTRO, extending fixed-rate full allotment and abolishing the sterilization operation from the SMP bond-buy plan - would be a "a powerful cocktail. That's got vodka in it," said Bosomworth.

The ECB is also concerned about weak lending to SMEs.

Another source was less sure the new staff forecasts would merit policy action but confirmed a package was under discussion should the Council decide to act. Some analysts believe a small cut in the ECB's interest rates would have little impact.

In February, ECB Executive Board member Benoit Coeure told Reuters the idea of cutting the deposit rate into negative territory was "a very possible option", before adding: "But you should not expect too much of it.

BOOSTING LENDING

Should it decide to cut rates, the ECB is looking at also deploying either a targeted long-term loan operation, or LTRO, or else announcing a purchasing programme to buy asset-backed securities (ABS) comprised of bundled SME loans.

The targeted LTRO, which ECB staff have been working on for weeks, would come with conditions attached on achieving a measurable increase of banks' lending to SMEs.

The operation could be even longer than 3-year LTROs the ECB deployed in late 2011 and early 2012 to head off a funding crunch.

"Three years has to be the minimum if we want to have an impact on boosting lending to small business," one of the sources said. "It may be for longer as well."

As an alternative to the targeted LTRO, the ABS purchase plan would see the ECB buy bundled packages of SME loans. This could be announced in June with a view to coming into operation late this year, two sources said.

The idea behind this second option is to build the market in Europe for SME loans bundled as ABS, with a view to making it larger and more liquid to aid the flow of credit to the smaller firms that form the backbone of the euro zone economy.

While developing this purchase plan, the ECB is also lobbying banking regulators in Basel to loosen the capital requirements on banks holding high-grade ABS.

One of the five sources said the ABS purchase idea was on the table but, because it would take time to make it operational, the measure might not be announced in June.

Another said the ABS purchase plan for securitized SME loans was premature and not ripe for decision or announcement in June, adding: "What you should expect is an LTRO that could be even more than 3 years at a fixed rate."

That would lend teeth to the ECB's forward guidance on rates. Asked how conditionality of banks increasing lending to SMEs could be enforced, he said that there could be for example a 4-year LTRO at a fixed rate of 25 basis points with an interest rate penalty if a bank did not meet the conditions.

NO QE

The tools being prepared are consistent with measures Draghi identified in an April 24 speech in which he explained how the ECB would respond to three broad scenarios.

To respond to a de facto tightening of monetary policy caused by market moves like further euro gains, Draghi indicated the ECB could cut rates.

To deal with problems transmitting its policy to all parts of the euro zone, he said the bank could deploy an LTRO targeted at encouraging bank lending or an ABS purchase programme.

Under a third scenario of a deterioration in the medium-term inflation outlook, Draghi said on April 24 the ECB could respond with a "broad-based asset purchase programme" - potentially QE.

However, just a few days later - at a meeting with German lawmakers - Draghi played down the prospect of QE any time soon.

"He mentioned quantitative easing in this context but made clear that we're still some way off QE," a source who attended the meeting with German lawmakers said.

One of the sources who spoke to Reuters for this story also said QE was some way off but another said he could imagine further measures potentially being examined later this year.

"It's not QE yet," the source said of the package being prepared for June. "This is now, and autumn is later. You could think about some more things then if it is well prepared."

(Writing by Paul Carrel Graphic by Vincent Flasseur Editing by Jeremy Gaunt)

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