ECB: On Hold, with a Fiscal Boost

Published on October 12, 2015

At its last meeting on September 3 the Governing Council of the European Central Bank decided to raise the threshold it had initially set on purchases of individual issues of bonds in its QE Program (or PSPP, Public Sector Purchase Program, in ECB speak) from 25% to 33% of outstanding bonds.


That, combined with a negative HICP rate reading of -0.1% since then and a drumbeat of ECB officials assuring investors and the public of their willingness to provide more stimulus if need be, has raised market expectations the ECB will act perhaps at this upcoming Governing Council meeting on October 22 in Malta, and if not then, almost certainly by the December 3 meeting that will include the ECB’s quarterly Staff Macroeconomic Projection round.


*** While it would technically now be a simple matter for the ECB to announce an extension of its QE program at the upcoming October meeting beyond its slated September 2016 expiration date, we do not pick up any energy or consensus to do so at this point – much less for a push to increase the size or to broaden the composition of bond purchases for now. ***


*** Indeed, we expect the ECB will at its October meeting remain firmly in wait and see mode: continuing to indicate a willingness to ease if need be, but keeping the current QE program in place as it monitors upcoming inflation for signs the enormous drag from low energy prices may finally be dissipating as expected toward the end of the year. ***


*** We do expect markets to be reminded the QE program as presented is already open-ended, and the ECB has from the start stressed it will continue with it as long as needed, which negates the need to make or force any commitment from the Council to purchases beyond September 2016 at this point in time. ***


*** With the December meeting still two months away, the ECB will certainly keep its options wide open for then, but if its forecasts for a bottoming and recovery in inflation by the beginning of 2016 pan out, we believe the pre-disposition of the Governing Council may even then be to save ammunition, and keep the QE program as is. ***


*** Perhaps most interestingly, that decision may be colored by what we are detecting are cautious yet growing expectations that after years of fiscal contraction, Eurozone governments – namely Germany – could finally be contributing to the weak yet nevertheless real cyclical recovery in growth by as much as 0.2% to 0.3% of GDP on the fiscal policy side, their hands forced by the migrant tragedy and crisis. ***


Monitoring Oil, China, and Inflation


When ECB President Mario Draghi announced in September the decision to raise the bond purchase limit from 25% to 33%, the measure was presented as a technical adjustment to make room for potential future purchases of bonds from smaller issuers such as Slovakia, Slovenia, and Finland.


But it was also presented in no uncertain terms as a policy signal to reinforce an ECB willingness to boost its QE program if need be (see SGH 8/14/15, “ECB: More, If Needed”).


That of course in turn raised market expectations for a potential adjustment, as President Draghi has often said was possible, in the “size, composition or duration” of the QE program over one of the next two ECB meetings.


It has even fueled expectations as extreme as a potential further cut in the deposit rate below the current negative 0.2% level – an option we believe not even vaguely under consideration at this point by any ECB Governor.


And so over the last week or so ECB officials appear to be gently attempting to moderate some of the market expectations – at least for any imminent action – pointing to tentative yet positive signals such as on credit growth, credit availability, and historically low borrowing costs.


And while ECB officials, along with all their global counterparts, have expressed concerns over risks to growth from the international side – meaning China – the assessment of the Eurozone’s internal domestic demand is not all that bad, for a change. At the last ECB meeting there was wide agreement with Chief Economist Peter Praet’s assessment that the cyclical recovery base case was essentially intact.


The problem of course remains in the continued stubborn refusal of Eurozone inflation to stabilize and pick up as expected, led almost exclusively by continued weakness in energy prices.


But setting the impact of the low energy prices aside, ECB officials point out that service inflation is running at 1.3%, and core inflation, excluding food and energy is running at around 1%.


Furthermore, inflation across the Eurozone is now more homogeneous than it was in the past, after the sharp adjustments imposed by the austerity programs on southern countries during the fiscal crisis. And that downdraft is believed to now largely have run its course.


But the last forecast round on August 12 was completed before a further $17 dollar collapse in oil futures, used as an input into ECB projections. And that raised a good deal of trepidation at the September meeting with officials suddenly staring at what at the time seemed like an abyss of financial market turmoil and commodity price collapse.


The continued weakness in oil prices and current inflation readings that were supposed to have been bottoming further fanned concerns over a potential un-anchoring of long-term inflation forecasts, such as in five year forwards that were starting to drift from 1.8% to 1.7%.


But since then, markets, oil, and international risks have all subsided, to some extent.


And while the ECB staff will have to adjust their forecasts yet again in December, the expectation and hope, again, is that the temporary effects of low energy prices will indeed dissipate and drop off on a year on year basis, enhancing both overall confidence and the modest consumer-spending driven recovery that is in fact quietly starting to take hold, for example, even finally in France and in Italy.


With excess liquidity already at 100 billion Euros and the PSPP (QE) only one third of the way into its launch, at this juncture we believe the only wild card to a hold in October would be a tightening of financial conditions through an unexpected and dramatic further bout of market turmoil, and with it a spike in the Euro perhaps to 1.1700 that so caught the attention of the Governing Council in August.


But officials have been doing their best to wax dovish on the differential between the Eurozone and US interest rate cycles, successfully containing if not weakening the Euro, and with markets largely recovered, and the Fed still banging the drumbeat on a potential 2015 rate hike, we do not think they will be faced with that challenge.


The inflation picture should be clearer by December, and with it one would hope the outlook for global risks and energy prices.


But perhaps most intriguingly, the new year we are told may herald a new dynamic not seen in the Eurozone in years, the prospect for actual stimulus from the fiscal front.


On Stimulus and Migrants into Germany


There has been a good deal of debate over the economic impact of the humanitarian crisis in the wave of refugees into the EU that started this year and is expected to continue into 2016.


But we were surprised to be pointed to it by ECB officials as a potential source of up to a 0.2% to 0.3% boost, even if temporary, to Eurozone GDP.


The influx of refugees, especially the 800,000 expected eventually to hit Germany, will without a doubt put a strain on national budgets and social welfare systems. But it is also expected to stimulate a flurry of economic activity in building housing, hiring teachers, and in the creation of other jobs, even if temporary.


For Germany, our understanding is that the spending on the refugee crisis may at least for 2016 reduce the country’s budget surplus into balance. Ironically, the loosening of purse strings that years of exhortation from US Treasury Secretaries and Socialist governments across the south of Europe could not achieve, the humanitarian crisis may finally bring about.


And to put the 800,000 number in context, we were reminded that at the time West Germany successfully absorbed (albeit not without some difficulty) six hundred thousand transplants from East Germany from 1989 to 1990 after the fall of the Berlin Wall (and roughly 1 million more until 1997), and an influx of some 1.2 million migrants from central and eastern Europe between 1989 and 1999.


Furthermore, when it comes to the Eurozone as a whole, the aggregate room to maneuver on the fiscal side has unquestionably increased from the dark days of the Fiscal Crisis of 2012-13.


The Eurozone is expected to hit an aggregate deficit to GDP level of 2.4%, well below the 3% Stability and Growth Pact target this year, and that deficit is forecast we are told, all else remaining equal, to drop down to below 2% by 2017.


And even though France is still battling with the Commission over its deficit targets, and Belgium and the Netherlands will not deviate from their sound fiscal policies, there are signs of fiscal easing coming for example from Spain and Italy, which are both planning to cut taxes in their 2016 budget plans.


Of course for there to be any meaningful stimulus, the main impetus will need to come from Berlin. That day may finally be here.

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