Expectations for yet another round of easing measures from the European Central Bank have soared since the release of a negative 0.2% preliminary CPI inflation print for August, that while representing just one data point, still served to highlight the ECB’s ongoing challenges in steering the eurozone through its severe pandemic induced disinflation and growth shock of 2020.
** This Thursday’s Governing Council meeting will include quarterly forecast revisions that would typically help pave the way for policy action, but the changes from last quarter’s baseline forecasts will not be enough to warrant even more monetary stimulus from the ECB – at least not yet.
** Indeed, while the ECB will continue to flag downside risks, the growth numbers for 2020, while brutal, are not quite as bad as initially feared, and will be tweaked up. And as a practical matter, after a typical seasonal drop-off in the pace of bond purchases over the summer, the ECB can easily step up its Pandemic Emergency Purchase Program (PEPP) within the current “envelope” if needed to support the economy and markets through the fall and heading into the winter.
** The real source of concern is the momentum and downside risk to the strength and durability of the rebound going into 2021, and which are likely to be revised downwards. As such, the ECB will leave the door open to further stimulus but will wait, barring any surprises, until the next forecast round at its December 10 meeting to further assess the degree of additional accommodation, if any, that may be needed.
** We therefore expect ECB President Christine Lagarde on Thursday to stress, as always, the ECB’s readiness to use all tools as needed at its disposal, and the importance of the fiscal measures announced to date for growth next year. But we also expect her to stop short of steering markets towards thinking a decision to ease further is a fait accompli.
** As to the form of any additional stimulus that might be taken, the predisposition within the Governing Council appears at this point to remain towards further asset purchases and another extension of the massive 1.35 trillion euro Pandemic Emergency Purchase Program (PEPP), that was topped off already once in June of this year to run through “at least” June 2021, as opposed to deeper rate cuts.
** Still, the Governing Council will not rule out a further cut in the deposit rate, especially as they believe the current negative 0.5% deposit rate has not yet hit its “effective lower bound.” But even while a rate cut would have a direct impact in weakening the euro exchange rate, the ECB is sensitive to the deleterious side effects of a prolonged regime of deeply negative rates, and we believe will continue to gravitate to bond purchases, which arguably could have the opposite impact of helping inflate the euro along with European risk assets.
** The mere mention of the impact of the rising euro on inflation forecasts by ECB Chief Economist Philip Lane nevertheless caught the market’s attention, if anything for the timing of the comments as the currency approached 1.2000 US dollars. But that comment was more a verbal “speedbump” in an attempt to throw a little two-way pricing into the currency markets after a bout of dollar weakness fueled by an increasingly dovish message from the US Federal Reserve, rather than anything even remotely resembling a line in the sand.
** Furthermore, while there is little question about the disinflationary impact of a strong or strengthening euro, the run up in July and August from 1.1200 to 1.2000 is seen as not just about Fed policy, but also as a reflection of a relatively more positive outlook from investors, at least at that time, on Europe’s management of the pandemic and its prospects for a return to more “normal” economic activity.
** In the big picture, ECB officials also note there has been little in the way of complaints from industry over the level of the currency, which is far more concerned over the risks to the course of the pandemic itself, Brexit talks, trade issues with the US, and ongoing weakness in Latin America and other emerging markets. Nevertheless, in the words of one ECB official, Lane’s comment was “good in showing we are not ignoring the currency level.”
** With regards to inflation and in particular the weak August inflation print, the ECB will point to extenuating circumstances that may have exaggerated that drop – late summer sales, German VAT tax changes, and COVID related measurement challenges – even while acknowledging the disinflationary risk and impact of the pandemic. Of far greater concern than one data point to the ECB is a potential continued slide in inflation expectations, reflected already in the downward drift of long-term survey forecast expectations to 1.7% on headline and 1.6% on core.
** Managing inflation expectations will fall squarely into the ECB’s Strategic Review, and our understanding is that ECB staff have already scheduled a slew of meetings on topics like inflation measurement and targets from next week on to feed to their Governors as they resume the Strategic Review of the ECB target that was put on hold due to the pandemic.
** Our presumption, once the review is completed at the end of the year, is that the ECB will scrap the “below but close to” definition of its 2% target to a flat 2% target, already touted by the increasingly influential ECB Board Member Isabel Schnabel – and a German to boot – for its simplicity, as well as significantly by hawks including Dutch National Bank President Klaas Knot, in addition to the doves.
** As to overshooting the target, the ECB, like their Fed colleagues across the Atlantic, have espoused the merits of a symmetric approach already for well over a year, even while keenly sensitive to the credibility challenge in going too hard on that message after missing to the downside for so many years.
** In the meantime, in contrast perhaps to the increasing risk of a waning fiscal impetus in the US, the ECB is eagerly looking for a helping hand for 2021 from the significant fiscal stimulus that has been pledged but not yet disbursed both on the national and European Union levels. Most notable is the 750 billion-euro EU Recovery Fund that, together with the 1.1 trillion euro 7-year budget, are now the subject of negotiations between the EU governments and European Parliament.
** A deal on the Recovery Fund is expected by the mid-October EU summit in order to leave time for ratification by national parliaments before year-end. But before that can happen, EU finance ministers will meet this Friday and Saturday to address concerns, shared by the EU parliament, that in their eagerness to conclude a deal they may have gone too soft on the “rule of law” conditionality for disbursement of funds that was pointedly targeted at the governments of Hungary and Poland, changes which, not surprisingly, the two countries are now threatening to block.