The central bank has turned a little more dovish on interest rates amid ongoing signs of economic weakness and speculation of new, cheap loans to banks.

The European Central Bank (ECB) recently cut its 2019 growth projection, acknowledging that risks to the outlook for the euro-area economy had increased. One of the biggest surprises in the global economy has been the eurozone's weak performance. Why is the region continuing to surprise negatively? The problem is that the eurozone's three biggest economies — Germany, France, and Italy — are barely growing. In Germany, businesses are nervous about the global outlook, and the struggles of the auto industry have had a big impact. Italy's economy contracted in the fourth quarter of 2018, largely due to weak domestic demand and the slowdown in its main trading partners, such as China and Germany.

The political stresses in the region may be affecting economic data. In France, civil protests have started to weigh on the economy. The chaos surrounding Brexit — prompted by the United Kingdom's parliament voting to reject Prime Minister Theresa May's Brexit deal in January 2019 — has weighed on investor sentiment. In addition, Trump's trade protectionist measures have harmed business confidence since the eurozone is a big exporter to China and to emerging markets.

Was the ECB wrong?

Regional policies may have played a greater role than we anticipated. Although Germany relaxed fiscal rules this year, the overall policy stance is quite tight. In addition, the failure to move forward on the eurozone's financial architecture has played a role in the conflict with Italy and the slow progress in dealing with the region's banking system. Italy's populist government had clashed with the European Union over the country's fiscal policy. There is also a possibility the region's monetary policy was too tight.

One of the biggest surprises in the global economy has been the eurozone's weak performance.

Recent research illustrates the inaccuracies in the ECB's inflation and unemployment forecasts. The forecast errors have been large and persistent. Indeed, the estimates for core inflation have been too high since they were first published in 2013, and the forecasts for unemployment have been too low. This strongly suggests that the ECB's assessments of the eurozone's economic fundamentals were wrong. The ECB was running an easy policy during this period, including quantitative easing (QE). However, the policy stance may not have been as loose as the ECB believed because of the stresses in the banking system. Perhaps, the Germanic wing of the governing council, the decision-making body of the ECB that consists of six members of the executive board and 19 national central bank governors, was just too strong to put a looser policy in place.

Eurozone GDP continues to slip

A new type of stimulus

The ECB recently shifted its policy message. At its meeting on January 24, ECB President Mario Draghi warned of "downside" risks to economic growth in the region and reaffirmed the central bank's stance to keep key interest rates at their present levels through the summer of 2019 and "longer, if necessary." The central bank left policy on hold at the policy meeting. Draghi said he did not think the markets were wrong in their assessment that there would be no interest-rate increases this year.

The central bank ended its €2.6 trillion bond-buying program, or QE, in December 2018, but will keep its plans to reinvest cash from maturing bonds for an extended period of time. There are now expectations that it will turn to other instruments to keep credit flowing. A new round of cheap multi-year loans to banks, known as targeted long-term refinancing operations (TLTRO), was widely seen as the first port of call. Draghi said in January that TLTROs had been raised by several policy makers, but no decision had been taken.

There is renewed talk about the possibility of moving away from a negative deposit rate to improve the position of the region's banks. However, it will be hard to raise the deposit rate without sending a hawkish message, and it may well be that this is where the design of the TLTRO will be important. The ECB does not want to tighten its stance, even though, like the Bank of Japan, it is worried about the harmful side effects of its current policy.

Next: Keeping China afloat

More from Macro Report
Download the Macro Report (PDF)

The global economy continues to slow. But there are signs that more supportive policies, including a dovish U.S. Federal Reserve, will keep growth within a certain range.