ECB: Consensus and Triggers

Published on April 3, 2014

The most important step the European Central Bank Governing Council took today by far, arguably much more important than a limited refi cut or other such measure would have been, was in forging and publicly acknowledging a consensus that QE – large scale bond purchases – was a tool that absolutely could be used if need be, and one which could be utilized without violating the ECB mandate. Critically, that consensus was publicly labelled as unanimous, meaning, for anyone not paying attention, the German Bundesbank was also on board.

That the Bundesbank has been sending hints and smoke signals, albeit somewhat mixed, of a softening in its resistance to bond purchases in recent weeks does not diminish the significance of today’s agreement as a Governing Council to go public with such a communication, which we have been flagging to expect in the run up to today’s meeting (see SGH 2/28/14, “ECB: Signaling the QE Option” and SGH 3/26/1, “ECB: Quick Note on ECB”).

The key points we took from today’s policy decision and presser are:

–          Up to now, our understanding has been that a lack of consensus on forging a common stand on QE has hampered the ECB’s recent willingness or ability to take some of the more limited conventional policy tools now left at its disposal (refi cut, SMP liquidity, LTROs). That obviously changed at this meeting, with perhaps much of the groundwork to the new consensus laid down in the March meeting. From SGH 2/28, “Signaling the QE Option”: One challenge with taking any of the smaller measures is that the ECB officials understand they will immediately have to address what they would do to ease next if needed, and that would be large scale government bond purchases.

–          On QE itself, the structure and transmission mechanism of the Eurozone and the US are clearly different, and the Eurozone transmission mechanism is mainly through its banks rather than through the capital markets as in the US (meaning the effectiveness and details of an European QE program may be different). But Draghi has publicly also clarified that the discussions on potential purchases of ABS securities, focusing on regulatory changes, are separate from what is meant by QE – which is the purchase of the deeper sovereign bonds. That clarification and consensus on QE is one reason why peripheral sovereign bonds, which have been rallying even at compressed levels on the talk of potential QE, have continued to rally today.

–          On the potential makeup of the bond purchases if they do embark on QE, we have already been asked numerous times if the ECB would buy bonds on a GDP-weighted basis or on a bond market-weighted basis, and we frankly do not know the answer, and suspect that sort of analysis is a bit ahead of where the Council actually is in its discussions. Our initial thinking is that, if QE is undertaken, the ECB may favor structuring bond purchases along a non-politicized metric such as the ECB “key,” which is GDP and population weighted rather than a straight GDP or bond market weighting. The answer to that question obviously has important implications for the potential weighing of relative purchases in various bond markets. The chatter over purchases of foreign bonds as a way of “circumventing” any mandate issues we believe to be just that, market chatter and speculation. In other days it used to be called outright FX intervention.

–          As to the IF and WHEN of QE, there is obviously consensus that we are not “there” yet, but there is clearly no consensus yet on what the trigger for QE would be. The differences on the Council over the dangers of even the current levels of low inflation have been stated at times in public, for example between Bank of Spain Governor Luis Maria Linde and Bundesbank President Jens Weidmann.

But the metrics are shaping up as follows:

–          For one, the ECB has been ready to dismiss to some extent the March 0.5% headline and 0.8% inflation readings, and most Street analysts, used to being disappointed by the ECB, were almost proactive in predicting this. But in being so many times bitten, the Street in fact went too far, as even despite the ‘’Easter” and energy effects, there was a degree of weakness in the number that raised some eyebrows in the ECB.

–          The Governing Council has gone out of its way to reassure that April inflation should bounce up from the already dismal March figures. That is quite a low bar for “success,” but if that bounce does not materialize, we expect the June meeting to be a live one.

–          The other primary trigger is the Euro, and if it strengthens enough to tip the ECB’s inflation forecasts off base. Given that those forecasts are already under some risk of allowing for a prolonged danger zone of low inflation, we do not believe that bar is very high (we would suspect that, all else being equal, the mid-1.40’s could do it), but for now the verbal intervention is capping the Euro rally.

–          To a far lesser extent, one other trigger is geopolitical risk, but we believe the ECB thinking for the most part is in line with our own in expecting an ongoing de-escalation of the Ukraine crisis that will keep that geopolitical risk to a minimum (see SGH 3/10/14, “Ukraine: A Post-Crimea World” and SGH 3/17/14, “Ukraine: Shifting Battle Lines”).

–          On inflation, we did notice an interesting verbal sleight of hand by President Draghi that seemed not to have been challenged: he characterized the 2016 inflation forecast that was rolled out in the March review and forecasting round of 1.5% inflation (going to 1.7% by the 4th quarter) as being “close to 2%,” which is of course the ECB’s mandate. This is a nod to Bundesbank officials, among others, who have curiously maintained that even the current inflation figures are within the ECB mandate – at least if you strip out food, energy, Easter, and all the peripheral economies that is. The fact that the mandate is a headline mandate and not a core mandate seems to be a bit confused, but we will leave it at that.

The ECB has, as we have been expecting, shown a clear awareness that there has to be some credibility to its threat of action if it misses further on an already dangerously low inflation mandate. It did not choose to dither or engage in tangential and ineffective chatter in order to play with the Euro, such as focusing on the Fed and rate differentials with the US for example as expected by some, and did not simply repeat its mantra about keeping rates low due to the Eurozone’s large output gap.

After last month’s somewhat stilted monthly ECB meeting and communications that led to an upward pop in the Euro, requiring a slew of subsequent “clarifications,” today’s meeting marked an important step forward in forging a unified consensus and communication on the ECB’s critical risk management options.

(Those interested may also listen to the 3/26/14 SGH Bloomberg interview Podcast, “SGH’s Ghahramani Says Draghi to Lay Groundwork for Move”).

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