My expectations from the ECB on Thursday

The ECB (the Monetary Policy Account -MPA-, Draghi, Coeure, Mersch) has sent over the last few weeks a clear message: there is downside risk to the €-area economy, coming in particular from emerging economies.

And the message is quite specific, not just a generic assessment: the September projections were admittedly already too optimistic when they were published. The changes of exogenous variables between the cut-off date for the projections and their publication implied a downward revision to growth and inflation. Since the projections were published a partial correction has taken place. Still, we could see in the ECB December projections for 2017 a reduction of inflation. While one could say that 1.7% inflation is consistent with the target of “lower but close to 2%”, it would be difficult to maintain this position if inflation would move further down, say to 1.5% or below. Similar considerations apply to growth, projected at 1.8% for 2017, close to commonly assumed potential. In a way, the September projections foresaw an economy moving back to the traditional, €-area “2-2” paradigm (2% inflation – 2% growth). A downward revision of this expectation, and in particular of inflation for 2017, if indeed it comes, would be, in my view, a set-back in bringing back the €-area economy back to normality and the main reason for a further monetary policy easing. This is the winning argument in the Council. 1)Coeure: “That 2% inflation target is really the anchor for the whole recovery process in the euro area. It is very important that it comes as quickly as possible.” The result would be that the market expectation that interest rates would remain very low for quite some years, as I illustrated in a previous post 2)Should we worry that we have about the lowest interest rates in the history of humanity? would be further reinforced.

The importance of inflation projections for monetary policy decisions means that, also considering the lack of drama I will present in a while, the ECB is unlikely to announce new moves in October. December, instead, when new projections will be available, is a likely date. A further element to target December as the date for new measures is the fact that the projections presented at that time, like those presented in June, are prepared by the staff of the entire Eurosystem, unlike those presented in March and September, which are prepared by the ECB staff alone. Still, the most important factor deciding if and when new measures will be announced will be the assessment of objective economic conditions, in particular regarding inflation. The ECB is now also, like the FED, clearly data dependent.

Let me add here that the convergence of inflation within the €-area, also noted in the MPA, adds value to the inflation indicator for monetary policy: it is no longer the case that there is too low inflation in the €-area mostly because of the necessary adjustment in the periphery. This convergence, together with those I will mention in a minute about growth, cost and quantity of credit, indicate that the “macroeconomic divide” between North and South in the €-area is becoming less visible.

At the same time there is no drama or urgency to take new measures 3)Mersch: “It is too early to judge whether these factors will cause lasting changes to the trajectory that the ECB expected inflation to follow. In particular, more time is needed to determine whether the loss of growth momentum in emerging markets is temporary or permanent in nature and to assess what is driving the fall in commodity prices and to what extent falling oil prices will have second round effects.” :
1. The oil price has stabilized and this has an obvious effect on inflation going forward but also, unexpectedly, on 5y5y break-even inflation. Inflation in five years over the subsequent five years should have nothing to do with the price of oil today. Let me note here, en passant, that the MPA even dares using the taboo term: un-anchoring of inflation expectations. “It was noted that the correlation between oil prices and inflation expectations had existed for some time, but in the past year and a half the link between current inflation and inflation expectations appeared to have strengthened considerably. This could be seen as a sign of an unanchoring of inflation expectations which required careful monitoring, while also pointing to possible shortcomings in the market-based indicators and in the functioning of the underlying market segments.”)) You remember that having inflationary expectations firmly anchored was until recently, to my surprise and disagreement 4) From firmly to weakly anchored, or the importance of an adverb!Should we worry that we have about the lowest interest rates in the history of humanity?  , a mantra in Draghi`s communication.

2. Activity is developing at decent, if anaemic, pace. Indeed there seems to be something of a “portfolio effect” at work in the aggregate €-area growth rate with possible loss of brilliance in Germany and less gloom in Italy.

3. Credit quantity is moving at a decent pace, with the improvement particularly visible in non-financial firms.

4. Credit cost is coming down, in particular in the periphery.

Overall the last three factors confirm the point I made above about the macroeconomic divide having become less visible.

An important factor is that no sign of disagreement is visible in the Governing Council about the assessment of economic conditions and prospects. 5)“The Governing Council could also forcefully underline its willingness and ability to act, if warranted, by using all the instruments available within its mandate, and stress that its asset purchase programme provided sufficient flexibility.”

The only faint signs of non-unanimity are that the agreements in the MPA are defined as “broad” and “wide”, not unanimous. But this is not quite enough to say that hawks are in clear disagreement with the idea that further action may be needed. Weidmann opposition seems to be quite silent these days, both within the Council and outside. This may reflect different points of view within the Bundesbank, with the economic department being in favour, or at least not against, QE while the legal department remains opposed. It remains to be seen what the attitude of the hawks will be if and when new measures will be considered, it is safe to say, however, that there is currently little indication that they will be strongly opposed.

The Governing Council of the ECB thus appears much less divided than the FOMC. This is, however, understandable, given that the Council does not have to take an urgent decision (in the case of the FED also not doing anything requires, as we have seen, a difficult decision).

Which moves could be eventually considered by the ECB?

There is a statement in the MPA which raised my curiosity, but not that of other observers, and I am curious why they are not curious: “the Governing Council remained willing and able to act, if necessary, by using all available tools within its mandate, including the flexibility of its asset purchase programmes in terms of adjusting their size, composition and duration.” My curiosity is specifically about “All available tools” other than modifications of QE.

Which are these tools in addition to QE? On the latter, we know that the ECB could act on size, composition and duration, with prolongation the most likely change. Let me note, en passant, here that my idea that they could extend the purchases to corporate bonds is nowhere to be seen in ECB utterances. So, from this point of view this adaptation does not seem likely. However there is evidence that corporate bonds are suffering, relatively to sovereign and corporate bonds, from not being purchased by the ECB. Indeed since the QE program has started in January the yield differential of corporate to sovereign bonds has more than doubled, from about 40 to around 100bp, as can be seen in the chart below.

Chart 1- Spread of Corporates vs Sovereign bonds

Corporates vs SovereignsSource: Markit

This could push in the direction of extending the eligibility beyond the public corporations that the ECB already buys. After all, is there a big difference between buying a public company like ENEL 6)The latest issuers added to those eligible for ECB purchases are: Työttömyysvakuutusrahasto (TVR), ÖBB-Infrastruktur AG, Autobahnen- und Schnellstraßen-Finanzierungs-AG (ASFINAG), Infraestruturas de Portugal S.A. (IP), ENMC – Entidade Nacional para o Mercado de Combustíveis E.P.E, Ferrovie dello Stato Italiane S.p.A., Terna S.p.A. – Rete Elettrica Nazionale, ENEL S.p.A., SNAM S.p.A., Administrador de Infraestructuras Ferroviarias – Alta Velocidad (Adif AV), SNCF Réseau, Caisse Nationale des Autoroutes (CNA), DARS d.d. , in which private investors are important shareholders along the state (the Italian Treasury ministry has 26% of equity), and buying a public company like Volkswagen (sorry for making this example!) where the a regional state has an important minority participation?

If there are no signs of extending the assets eligible for QE to corporate bonds there are even less signs of a possible action on inflation derivatives. This pet idea of Juliusz Jabłecki and me 7)A help for the ECB from the derivative market  is still languishing un-noted. Maybe only despair in  reaching again the 2 per cent inflation objective, is ever this would develop, would be needed for the ECB to consider it.

Of course one possible, less exotic, tool would be a further reduction of the MRO rate. This would be easy to do. However, in my view, the obstacles are:
1. Draghi has excluded the possibility of a further cut in the past,
2. It is not clear how effective a reduction say, from -20 to -40 basis points would be and I doubt that the ECB can go as low as the -75 basis points of the SNB.
3. This would make the life of banks even more difficult, with possible repercussions on their ability/willingness to take deposits and make loans.
On balance, I do not see this move as very likely.

While not being sure about what he could say, I would not exclude that Draghi could reinforce the easing message by being more specific on the tools the ECB could use, if needed. He could, for instance, refer to a discussion in the Governing Council about specific possible future moves, beyond the litany of “adjusting the asset purchase programmes in terms of size, composition and duration”. This, of course, would be taken as a strong indication of what they could announce in December. Let me note here, again en passant, that I regard it in any case as unlikely that the ECB will move from 60 billion purchases per month in September to zero on October 2016. At the least, I would see a gradual tapering after that date. A tapering, however, would be the weakest further action possible. Another issue that soon or later will emerge is whether the ECB will reinvest the proceeds of maturing bonds, like the FED, or not. So far they have not reinvested the maturing bonds from old programs (SMP, CBPP1 and CBPP2), but of course the current purchase program is a different issue, being much larger.

On the € foreign exchange rate I do not expect much innovation with respect to the usual refrain that the exchange rate will reflect the different monetary policies of Europe and the US, that the foreign exchange is an important variable but not a target and that it has an obvious effect on inflation (with an elasticity of 0.05-0.06).

In conclusion, should the ECB have to further reduce in December its inflation projections for 2017 it would be very difficult for it not to announce new measures. If already in October a reduction of the inflation projection was probable, Draghi could send some hints to a possible move in December.

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References

↩ 1. Coeure: “That 2% inflation target is really the anchor for the whole recovery process in the euro area. It is very important that it comes as quickly as possible.”
↩ 2. Should we worry that we have about the lowest interest rates in the history of humanity?
↩ 3. Mersch: “It is too early to judge whether these factors will cause lasting changes to the trajectory that the ECB expected inflation to follow. In particular, more time is needed to determine whether the loss of growth momentum in emerging markets is temporary or permanent in nature and to assess what is driving the fall in commodity prices and to what extent falling oil prices will have second round effects.”
↩ 4.  From firmly to weakly anchored, or the importance of an adverb!Should we worry that we have about the lowest interest rates in the history of humanity? 
↩ 5. “The Governing Council could also forcefully underline its willingness and ability to act, if warranted, by using all the instruments available within its mandate, and stress that its asset purchase programme provided sufficient flexibility.”
↩ 6. The latest issuers added to those eligible for ECB purchases are: Työttömyysvakuutusrahasto (TVR), ÖBB-Infrastruktur AG, Autobahnen- und Schnellstraßen-Finanzierungs-AG (ASFINAG), Infraestruturas de Portugal S.A. (IP), ENMC – Entidade Nacional para o Mercado de Combustíveis E.P.E, Ferrovie dello Stato Italiane S.p.A., Terna S.p.A. – Rete Elettrica Nazionale, ENEL S.p.A., SNAM S.p.A., Administrador de Infraestructuras Ferroviarias – Alta Velocidad (Adif AV), SNCF Réseau, Caisse Nationale des Autoroutes (CNA), DARS d.d.
↩ 7. A help for the ECB from the derivative market