Gearing up for global stimulus, as Greek election looms large

• Future of the euro hangs in the balance, as Greek election approaches  
• Policy makers mull over need for further stimulus, but what more can they do?  
• Bank of China cuts interest rates for the first time since 2008, as growth momentum fades  

Are global policy makers gearing up for another bout of stimulus? With the euro area fast approaching a potential tipping point, credit markets in a state of flux and growth momentum fading pretty much everywhere, the prospect of further stimulus - possibly coordinated - has risen appreciably. Although both the BoE and ECB opted to keep policy unchanged this week, the Bank of China’s decision to cut its benchmark rates by 25bp for the first time since 2008 is clear recognition that growth concerns are no longer limited to the developed world.

In Europe and the US, policy makers are holding fire for now. We believe the question, however, is not whether policy makers will act, but when and, just as importantly, how? We suspect the decision of the ECB and BoE to hold off from further stimulus this week was largely motivated by their desire to await the outcome of the Greek election on 17th June and the potential ramifications of the Europe-wide banking reviews currently under way by the rating agencies. We may get a better indication of the prospects for policy stimulus in the UK on Thursday, as both the Governor and Chancellor are scheduled to speak at Mansion House.

In the ECB’s post meeting press conference on Wednesday, President Draghi acknowledged that a few members had favoured an immediate cut in interest rates and that recent indicators had 'increased downside risks to the economic outlook'. Although he gave no clear steer that the ECB would take further action, we suspect that their hand could well be forced by the unfolding events in Europe. Similarly, with recent indicators pointing to a clear slowdown in UK and US growth, and oil prices having tumbled below $100 - since late March Brent Crude has dropped by over 20% - it seems only a question of time before the BoE and Fed act again.

The big dilemma is what they do? With the limits of conventional monetary policy having already been effectively reached, their toolkits are limited to liquidity support operations or some broader form of Quantitative Easing. While both are likely to be forthcoming if market conditions continue to deteriorate, the issue is not one of a lack of liquidity. The massive increase in bank reserve balances in recent years illustrates that liquidity is there. The problem is that, because of the extreme economic uncertainty, the liquidity is not circulating quickly enough to create a virtuous circle of stronger demand, stronger income and stronger employment.

With government bond yields hitting record lows, the case for Western central banks pumping yet more cash into the system through government bond purchases is questionable. Instead, there appears to be a growing recognition that central bank toolkits should be augmented - to include purchases of broader asset classes - and that more needs to be done on the fiscal side. Both of these, however, present their own problems, particularly with many governments having staked their political reputations on fiscal consolidation.

It is against this seemingly intractable backdrop, that markets continue to fluctuate. A successful resolution to the euro crisis would be decisive in restoring economic confidence, but it remains far from clear that this is possible in the current climate. There are reports that EU policy makers will meet this weekend to discuss a bailout for the Spanish banking system. Agreement on this would be a positive sign, but with the Greek election on 17th looming large, the prospect of any major improvement in risk sentiment looks highly limited until this flashpoint is cleared. From a market perspective, the most positive result would be a decisive victory for the fiscal conservatives, although quite what happens then is unclear. With the G20 meeting on the 18th, and a key EU leaders' summit on the 28th, there is no shortage of event risk to concern markets over coming weeks.

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