ECB’s Draghi to hold the line on dovish policy outlook

Posted on March 8th, 2017

The outlook for the Eurozone economy has improved with business confidence surveys at multi-year highs and a stronger global backdrop; important for the Eurozone given its relatively high share of exports in GDP.  Headline inflation has jumped sharply to surpass the ECB’s medium-term target for the first time since Jan-2013.  This may be generating some thoughts of a less dovish ECB statement on Thursday.  However, the ECB still has nine months to go on its current asset purchase plan and is under no pressure to provide further guidance until later in the year. There has been no pick-up in core inflation from 0.9% last year, still well below target.  Substantial spare capacity and headwinds from banking sector balance sheet repair remain.  Credit growth has continued but only at a modest pace. The outlook has improved, but the risks remain high; including Eurozone political risk, Brexit negotiations, Greek debt talks and US government policy uncertainty.  The ECB must weigh the odds that the USA imposes a border tax or pursues protectionist policies that threaten to disrupt the outlook for global trade.  As such, we still expect Draghi to state that there is scope to expand and extend the asset purchase plan if the outlook deteriorates.  The EUR has weakened in-line with a stronger USD in the last week, although it has out-performed most other currencies as French political risk has eased.  The path for the Eurozone’s return to balanced growth and sustainable 2% inflation remains long and uncertain. Extreme policy easing in the ECB, combined with rising rates in the USA, should push EUR to new lows in coming months.


Headline inflation jumps, core steady

Headline inflation has lifted globally, and the Eurozone is no exception, mainly due to a rebound in oil prices.  The Eurozone is the first of the major economies to release inflation data for February, and it rose to 2.0%y/y, now essentially on target (The ECB aims at inflation rates of below, but close to, 2% over the medium term).  Only the USA has higher CPI inflation at 2.5%y/y in January.  (Although the USA PCE deflator, preferred by the Fed, was only 1.9%y/y in Jan).

Core inflation measures have been mixed globally. CPI core (less food and energy) was steady in the ECB at 0.9%y/y in Feb.  It has been stable around this level for around 18-months.  This is off the lows in the Eurozone of 0.6%y/y in 2014.  Eurozone core inflation is lower than the USA, and UK, but above Japan’s core measure of only 0.2%y/y in January.



This core measure is still uncomfortably low for the ECB and supports the case for its current accommodative monetary policy.


ECB staff forecasts may rise somewhat

The ECB December staff forecast was for CPI inflation to average 1.3% in 2017 (well below the 2.0%y/y in Feb).  The staff projections anticipated a bump in inflation early in 2017 to fade due to the flattening out of the annual increase in oil prices (based on the oil futures curve).

The low in oil prices was in the first months of 2016, and thus the year-on-year comparisons boost inflation data in the first two to three months of this year.  Oil prices have been relatively stable since December last year, and should not offer a reason for an increase in the staff inflation forecasts.

However, the recent strong headline inflation readings, combined with improved global economic confidence might suggest scope for some improvement in the inflation outlook. The ECB staff forecast headline inflation to rise from 1.3% in 2017 to 1.5% in 2018 and 1.7% in 2019

The ECB staff said that it forecast core inflation to rise from 0.9% in 2016 gradually over the forecast horizon to 1.7% in 2019. (1.1% in 2017 and 1.4% in 2018).

On wages, it said it expects compensation per employee growth to rise from 1.2% in 2016 to 2.4% in 2019.


ECB rates policy stable

The ECB has left its rates policy unchanged for 12-months, with a deposit rate of -0.40% essentially acting as a floor for rates.  The ECB balance sheet has been growing again for over two years, ensuring excess liquidity and a tendency for cash rates to sit close to the deposit rate, at around -0.35%.

In January, the ECB repeated its rates guidance that they “expect them to remain at present or lower levels for an extended period of time, and well past the horizon of our net asset purchases.”


Asset Purchase Plan steady

The ECB’s “Expanded asset purchase program” (APP) includes the purchase of covered bonds, asset-backed securities, government bonds, and corporate bonds.  Total purchases are targeted at EUR80 bn through to the end of this month.  They are scheduled to fall to 60bn per month in April and to proceed at this rate until the end of this year. And “in any case until the Governing Council sees a sustained adjustment in the path of inflation that is consistent with its aim of achieving” its inflation target.

In December last year, the ECB announced the extension of the APP beyond March 2017 to the end of 2017, albeit at the lesser rate of 60bn per month.  This might be regarded as the first step in tapering, but was notable at the time for extending the program for nine months, whereas many thought they would extend six months.

In December the ECB also announced it would ease the parameters of the APP to allow a wider range of securities to be purchased; including allowing purchases of government bonds at yields below the deposit rate (-0.4%) and purchases of shorter-term bonds (minimum maturity lowered from 2-year to 1-year). The EUR fell after the 8 Dec ECB policy meeting due to these dovish elements.

With nine months left to go on the current APP, there is little pressure on the ECB to comment on what happens next; although the press core will probably pressure ECB President Draghi to discuss a potential taper.  The official policy press release is likely to state no change in the rates policy or APP.

The ECB waited until the program had 3-months left to run in December last year before extending the plan.  On this schedule, the ECB may wait until September this year before giving the market further guidance.


Targeted Long Term Rate Operations

In addition, the ECB has targeted longer-term refinancing operations (TLTROs).  The latest series (TLTRO II) were announced 12 months ago.  These are loans to banks by the ECB that are designed to support bank lending to companies and households.  There were four operations announced starting in June 2016, each for terms of 4-years, at a rate as low as the Deposit rate (-0.4%).  The last is scheduled for 20 March, later this month. EUR399bn was allotted in Jun-2016, 45bn in Sep-2016, and 62bn in Dec-2016.


Capacity to ease further

A feature of the ECB President’s press conference and introductory statements has been to emphasize the capacity to further ease policy if required.

In January, the statement said, “If warranted to achieve its objective, the Governing Council will act by using all the instruments available within its mandate. In particular, if the outlook becomes less favorable, or if financial conditions become inconsistent with further progress towards a sustained adjustment in the path of inflation, we stand ready to increase our asset purchase program in terms of size and/or duration.”

When asked in the press conference why the statement did not also state that the ECB would consider reducing its APP if the outlook becomes more favorable,  Draghi described this as a “high-class problem”, suggesting the risks were mostly still to the downside.

However, the tone of the January statement concerning the outlook for growth and inflation had improved, as there is was no explicit statement on the balance of risks.


Improved business surveys

There are signs of further strengthening in the Eurozone outlook.  Business surveys and PMI data are around their highs in a number of years.  This suggests a possible upward revision to ECB staff forecasts and diminishing downside risks.


The global outlook has also improved, and this should also feed into stronger growth forecasts for the Eurozone.  Extra-euro exports of goods and services accounted for 27.5% of Eurozone GDP in 2015, significantly more than 12.5% in the USA, 17.9% in Japan and 24.3% in China (Structure of the euro area economy –  As such, the European economy is more leveraged to global growth in trade than other major economies.


Weaker German factory orders

However, with still substantial spare capacity and no obvious improvement in core inflation, the ECB is hardly about to signal the path is clear to resurrecting sustainable 2% inflation.

Some other hard data are less supportive.  German factory orders disappointed falling sharply in in January by 7.4%m/m in total and 10.5%m/m for domestic orders, reversing gains seen in Q4.

Economic activity proceeds at a moderate pace – Eurozone Retail sales volume growth 1.2%y/y in Jan; Eurozone industrial production +2.0%y/y in Dec; German export value +3.3%y/y in Dec; Eurozone GDP +0.4%q/q and +1.7%y/y in Q4.


Recent market-based measures of long-term inflation expectations have ebbed


Risks remain elevated

There remains significant uncertainty; including repairing Eurozone bank balance sheets, ongoing Greek debt crisis, heightened Eurozone political uncertainty, Brexit negotiations,  US government policy uncertainty; including risks to global trade related to protectionist policies and a possible border tax in the USA.