ECB: Upside Communication Shifts

Published on March 3, 2017
SGH Insight
Against a backdrop of steadily improving inflation data and the likelihood that the quarterly economic forecast will be tweaked up at the meeting, our understanding is the Council will discuss the appropriateness of its current forward guidance language on Thursday, and there is a good chance President Draghi will agree to some changes to the wording of the ECB policy messaging.
Market Validation
(The Street, 3/9/17)
Speaking to reporters during his regular press conference in Frankfurt, Draghi told reporters that while the Bank's official forward guidance suggested rates could remain "at present or lower levels for an extended period of time", improving economic fundamentals would imply that the "or lower" clause is not likely to be applied, indicating a "lower sense of urgency" on further rate reductions.

The Bank also lifted inflation forecasts for this year and next and Draghi said that he and his Governing Council colleagues -- comprised of central bankers from around the Eurozone -- had agreed to remove a previous reference to the use of "all available instruments" in the Bank's policy toolbox.

The collective suggestions helped the euro gain sharply against the dollar, with the currency rising to as high as 1.0614 from 1.0555. Benchmark 10-year bund yields were also rising as Draghi spoke in Frankfurt, gaining 4 basis points to a two-week high of 0.41%

President Mario Draghi and the European Central Bank Governing Council will have a communications challenge on their hands when they convene this coming Thursday, March 9, for their monetary policy meeting.

But in contrast to so many meetings in the past, the issue this time will be in how to communicate good news, not bad – without prematurely raising expectations for policy shifts.

*** Against a backdrop of steadily improving inflation data and the likelihood that the quarterly economic forecast will be tweaked up at the meeting, our understanding is the Council will discuss the appropriateness of its current forward guidance language on Thursday, and there is a good chance President Draghi will agree to some changes to the wording of the ECB policy messaging. ***

*** That discussion over communications changes will center around two key points. One is the asymmetric bias to only increase asset purchases if needed to counter downside shocks. That was added by the ECB in December in order to temper any market over-reaction to the announcement of its tapered rate of purchases. The other is the long-standing asymmetric bias that ECB policy rates will be low, or lower, than current levels for the forecast horizon period. We believe they may adjust both, but especially the now stale message on rates. ***

*** By June, the ECB will know whether a political crisis that could hit the economy will have materialized from France (they are far less concerned about the Dutch elections). Assuming there is none, at the June meeting they will have a clean look at what they hope will be consistently stabilizing data. A timeline is envisioned in which they could then change their forecast and guidance more aggressively at the June meeting, and by the September meeting announce the actual next leg of the asset-purchase taper for 2018. ***

There will be no change on policy substance at the ECB meeting on Thursday. Given the dramatic political and economic developments of the last few months, it may seem like ages ago now, but the ECB is only now starting to implement its eight month, tapered-down pace of bond purchase from 80 billion to 60 billion Euros per month that was intended to carry through to the end of 2017.

Any changes at this meeting will be to bring their language more in line with the improving data.

Assessing the Stronger Data

It should by now be clear to all that 2017 inflation will be much higher than was forecast in December. The main policy question for ECB officials though is how that will feed through into the 2019 forecast? And while 2019 should also show some improvement, it is not yet really evident by how much.

The dramatic headline inflation increases of the past couple of months are clearly the result of the baseline effect of energy price rises, so ECB officials expect that tailwind to come off in the second half of 2017.

ECB staff will look to assess by how much the headline bumps filter through into 2018 and 2019 core inflation. And on the policy side, the question will be whether it is then possible to keep inflation sustained at the ECB‘s “at or slightly below 2%” target when the ECB reduces purchases?

The ECB has conducted studies that show, perhaps surprisingly, a degree of Eurozone economic independence for some time from the ups and downs of global trade.

This linkage disappeared essentially after the establishment of the ECB‘s Asset Purchase Program, or APP, their QE policy. So monetary policy is clearly critical, and the concern at present is when and by how much could that domestic demand be sustained with a reduction of purchases.

In the meantime, much of the underlying Eurozone economic data have come in better, so the ECB‘s underlying inflation forecast could and will go up a little.

Except for perhaps in the very near term inflation forecast, it will not be a significant shift just yet. But another month or two of this upward inflation pressures, and it will be difficult to explain why the forecast should not change more aggressively.

And that opens up June for a more significant forecast revision, and September for the discussion of potential policy shifts for 2018.

Two Key Messaging Tweaks

The ECB provides essentially two strands of forward policy guidance:

First, there is a bias to increase asset purchases again if needed that was introduced after the ECB announced the pace of bond purchases would be tapered from 80 to 60 billion Euros a month last December.

While we suspect it may still be premature, this could change. At the last meeting already one of the Council members suggested the guidance be moved to a neutral policy stance, i.e. bond purchases can go up or down.

Realistically, however, the ECB is on auto-pilot to complete its 60 billion Euros per month program from April to the end of this year. They will not want to create needless volatility and cast doubts on that. So changing that message will be tricky, and any shift in the language, if it were to happen, is likely to be marginal.

Second, there is a bias towards lower rates, which should be less controversial to scrap or amend.

The ECB has long maintained that rates will be low or lower for the forecast horizon. That message is very long in the tooth, and no one any longer thinks the lower part – a deeper cut in the deposit rate – will happen in reality.

The ECB is certainly not at the absolute lower bound of rates, and will continue to assure that they could cut deeper in theory, but Council members have really not thought or expected to do so now for probably about a year.

Meanwhile the data has been just fine. Week after week, month after month, it is showing improvement.

But for any actual policy shift, Draghi and his Council members have laid clearly what needs to fall into place: headline inflation has to feed into core; core has to be sustainable, and, the ECB has to assess that it is sustainable without the stimulus it is providing and will not falter.

In the back of their minds, there is an institutional memory of 2011, when theECB hiked too soon.

So in June, the ECB Staff and Governing Council can take a clean look at economic data while hopefully enjoying a window of stability on the political side (assuming the National Front’s candidate Marine Le Pen does not win in France). There will then be less risk that data will falter.

The ECB can then change its communication and forecasts a little more in June, and by September announce the actual next leg of the taper policy for 2018.

French Election Risk

The biggest near term concern politically is of course over the elections in France.

The rise of the populist Freedom Party of Geert Wilders in Netherlands is also a source of some concern, but there is less concern about elections there.  The assumption, shared broadly by political pundits, is that even if Wilders were to get 15-20% of vote, he still couldn’t lead a government, making the term “winner” a bit nonsensical in the Dutch system of a dozen parties ranging from far right to left to animal rights group rights activists.

In France, the centrist independent candidate Emmanuel Macron is seen to be the most pro-European candidate. If, as it currently appears, he does win (see SGH 3/2/17, “France: A Macron-Le Pen Runoff”), the biggest political risk will have faded for now, and come June the ECB would take a clean look at a longer series of economic data, and with a window of stability on the political side.

But that election risk will have to be cleared first.

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