ECB: Easing Despite Waning Urgency

Published on November 24, 2015

As the European Central Bank approaches its final Governing Council meeting of the year on December 3, financial markets are fully pricing in the announcement of an additional dollop of monetary policy easing – and are even pricing in odds for some more in 2016.

But President Mario Draghi and his allies will need to push this next round of easing through a Governing Council in which many members are pointing to data since late summer, when the door was first opened to further action, and even since the last meeting in October, that is stabilizing, if not showing modest signs of improvement.

This sense of a waning urgency within the Council on the need for aggressive additional policy measures – some would say any additional easing at all – may be reinforced by the better data we believe could include a stabilization if not improvement in the November CPI core print from last month’s 1.1% that will be released the day before the meeting.

*** We nevertheless believe consensus will ultimately be forged at this meeting to push the ECB bond buying program beyond the current September 2016 end date and to increase the monthly pace of asset purchases by a modest amount. That extension would be for another year into 2017, and the ECB may also communicate a balance sheet size target in the process. ***

*** The ECB is also very likely to cut the deposit rate by another 10 basis points deeper into negative territory, from -0.2 to -0.3%, as expected by markets now, with a good chance the cut could be deeper than that and what markets expect (see SGH 11/16/15, “ECB: Delivering in December”). ***

See details on these likely policy measures below:

But First, a Tricky Message

Truth be told, since the summer domestic demand across the Eurozone has proven more resilient than the ECB expected.

Even as the ECB will still point to “downside” risks, for instance, global “tail” risks have receded. The broader Emerging Markets have challenges for sure, but China has for one been taking policy measures that are expected to at least help cushion the downside risks of a hard landing, and the RMB has been stable.

And even on the inflation side, while oil prices are still weak (a boon to spending) and dampening upward price pressures, that weakness has been offset to a large extent by rising food prices and especially by a weaker Euro, taken down a notch by the greater certainty of a Federal Reserve rate hike and an ECB ease.

Indeed all that will likely point to a modest “mechanical” downward adjustment of 0.1% or 0.2% in the ECB’s 2017 inflation forecast and, with it, a modest extension of the forecast horizon for hitting the ECB 2% target. Those are revisions that may warrant more easing, but certainly not ones that scream for the need for overly aggressive measures at this point.

But the Eurozone economy is still nevertheless vulnerable to downside shocks, and that improving trend on both growth and inflation is coming from a very low base – Eurozone GDP for example is just hitting levels last seen before the 2008 financial crisis.

Furthermore, the ECB is already on an easing course firmly hinted at by no less than Draghi himself, in undeniably aggressive terms, and officials are well aware that easier financial conditions are in no small part due to expectations it will ease policy.

And one thing the ECB will not want to do is veer off course as some might say their colleagues at the Federal Reserve did in September (with apologies), only to run the risk of reversing and having to cut further down the road.

And so ease they will.

The details:

Extension of Bond Buying Program

*** We believe the Council will push its bond buying program beyond the current September 2016 end date and increase the monthly pace of asset purchases by a modest amount.  That extension would be for another year into 2017, and the ECB may with it communicate a balance sheet size target in the process. ***

An extension of the Asset Purchase Program (APP) beyond September 2016 is a relatively easy signal and has the benefit of serving as reinforcement to markets of the continued differential between US and Eurozone rates, and will reinforce further stimulus through a weak Euro.

But as we have written in previous reports, the need to commit to an extension at this point is not without controversy even in and of itself, raising questions as the Council has already stated in no uncertain terms since March when it launched its “QE” program that it can and will buy until that date “or if needed beyond.”

The extension will therefore be explained as being due not just to potential downside risks but also in terms of the need to reinvest the large amount of short term bills the ECB is already buying under the current program that will roll off around the currently scheduled end of the program in order to avoid a “cliff-like” effect down the road.

Furthermore, Council members are aware that the effectiveness and credibility of an extension will be enhanced through a modest widening in both the “scope” and “size” of asset purchases – now. The APP path may therefore incorporate elements both of front-loading now, and of a “tapering” down the line.

In order to address continued resistance from Council hawks skeptical of the merits or effectiveness of the APP, and certainly for an increase in its size and pace at this point, Draghi and his allies may point to an ECB study that attempts to quantify in basis points terms the effectiveness of the program to date in easing monetary conditions across the Eurozone.

But while Draghi has in the past effectively steamrolled the hawks when needed to achieve his objectives, he will still seek a reasonable and not slim consensus majority in the Council vote on the final package of measures approved, especially in light of the signs of resilience in the Eurozone economy.

We do not believe that will stop the ECB from increasing the size of purchases, but it will probably limit the scope of that expansion for now.

Deeper Cuts in Negative Rates

*** The ECB is also very likely to cut the deposit rate by another 10 basis points deeper into negative territory, from -0.2 to -0.3%, as expected by markets now, with a good chance the cut could be deeper than that and what markets expect (see SGH 11/16/15, “ECB: Delivering in December”). ***

As the ECB explores the limits of the negative lower bound on rates, there is a growing sentiment even among the more hawkish members that if there is room for further stimulus on the rates side, then it should probably be taken, as it constitutes more “traditional” monetary policy than bond purchases.

So interestingly, even as the ECB delves further into uncharted territory on negative rates, there is less controversy over this policy lever and a greater consensus to cut if needed than expanding “QE.”

But we suspect the Council will not hold separate votes on the different measures, but rather try to forge a consensus on “one or both or a combination of the two” before taking a vote.

One last point is that ECB officials are aware that the current market expectations are for one depo cut and part of another one sometime around the middle of next year.

And the ECB under Draghi has tried in the past when it does act to meet expectations and deliver a little bit more, as they did on January 22 of this year when they announced 60 billion Euros of purchases per month to trump expectations that had built in the markets for around 50 billion (see SGH 1/15/15, “ECB: Launching QE”).

But we have been warned that an upside surprise may be more difficult to achieve this time around, especially in light of the signs of resilience in the domestic economy and perhaps even waning concerns over global risks. We nevertheless understand the rate side to be a place where they could deliver beyond expectations.

And even if not, we would consider a package that delivers close to the expectations outlined above a robust round of stimulus on a fundamental level, and one that especially in light now of increased certainty over a near term Fed rate hike, may counter any temporary squeeze in what is without a question at this point a relatively crowded short Euro trade.

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