ECB: Not yet ready to set next steps

04 September 2017

Chris Scicluna

This week’s main economics event is undeniably Thursday’s ECB policy announcement, with markets looking for guidance on the outlook for QE in the New Year. But although Draghi might provide the odd clue, we don’t expect full clarity on the next steps for policy.

Given continued unease about the weakness of underlying inflation, and with some members concerned about a possible overshooting of the euro, Draghi was deliberately circumspect following the Governing Council’s July meeting. The ECB’s forward guidance was left unrevised, while Draghi was unwilling to offer a precise date for when the Governing Council might decide its next steps for its asset purchases once the current programme of €60bn per month concludes at year-end. Instead he merely stated that this would be discussed sometime in the autumn. But while it now feels like autumn has arrived in Northern Europe, after Draghi failed to address monetary policy issues in his Jackson Hole speech last month it is very difficult to see the ECB deciding those steps at this week’s meeting. Instead, we suspect that Draghi will simply note that the Governing Council has now tasked internal work on the precise options to allow a decision to be taken in Q4, most likely at the policy meeting in the final week of October.
 
Whatever the ECB decides with respect to its forward guidance this week should not substantively prejudge that key policy decision next quarter, although we would see no harm from it amending the language on QE, which currently specifies an easing bias. Certainly, the Governing Council seems bound to slow the rate of asset purchases from January, not least since – under the current programme and with some of the issuer limits within sight – the ECB would struggle to keep buying the targeted €60bn per month of bonds for many more quarters. More fundamentally, despite recent euro strength, there is no compelling economic case to keep buying at the current rate – the macro outlook simply does not merit it.
 
Indeed, when the ECB unveils updated economic forecasts on Thursday, we expect to see a modest near-term upwards revision made to its forecast for GDP growth, which was already at an above-potential 1.9% in 2017, 1.8% in 2018 and 1.7% in 2019. And while the stronger euro will likely see a slight downwards revision to its CPI forecasts for 2018 (1.3% headline, 1.4% core) and perhaps also 2019 (1.6% headline, 1.7% core), we expect its first predictions for 2020 to be within shouting distance of its inflation target of below but close to 2.0%.
 
That suggests there is still a case for continued asset purchases in the New Year, albeit only at a reduced rate, to give a further modest boost to inflation two years ahead and also to try to limit the risks of a harmful tightening of financial conditions (i.e. a taper tantrum) as the ECB gradually withdraws from the market. And while several uncertainties – including the future path of the euro, the outlook for external demand, and political risks associated with the next Italian election due by next spring – mean that the ECB might be unwilling even next quarter to set an end date for the programme, we currently anticipate the asset purchases being brought to a conclusion in Q318, and a first small hike in the deposit rate coming around the turn of 2018/9. We expect Draghi’s rhetoric this week to be consistent with that policy outlook.

Of course, investors will also be hanging on every word that Draghi has to say about the euro. But we don’t expect much new to emerge here either, and – given there is no evidence that the euro area’s external competitiveness has been hit by the recent currency appreciation – nothing that could be considered substantive verbal intervention. Indeed, a range of factors – including strong domestic and external demand, a tightening labour market, global commodity price shifts and maintenance of easy financial conditions – could offset some if not all of the impact of the exchange rate on inflation over coming quarters. So, this week we expect him largely to repeat what he said in his July press conference, i.e. that the euro was discussed and that the risks of an exchange rate overshoot have been acknowledged, but also that at least some appreciation of the euro has been appropriate given the recent improvement in the euro area's economic fundamentals, particularly relative to the other major economies. In all a message that does not suggest that the euro is playing a pivotal role in the ECB’s decision making at present.

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