When the European Central Bank Governing Council convenes tomorrow for its Monetary Policy Meeting, the main topic of discussion will be whether and how to tweak its forward policy guidance language given the improving, even if still tenuous, Eurozone inflation and growth data. An argument could already be made now on a strictly economic basis for a more substantial overhaul of the extremely dovish ECB forward guidance language, both on rates and on QE.
*** But any major changes will have to wait until the next meeting on June 8, in order to clear the potential downside risk of a shock outcome in the May 7 second round of the French Presidential elections. This has been the time line and sequencing envisioned since the turn of the year, namely, if all goes well, to broadly overhaul guidance language in June, and to then discuss options for tapering the ECB’s Asset Purchase Program in September. That should provide certainty to markets by December, when the extended QE program expires (see SGH 3/3/17, “ECB: Upside Communication Shifts”). ***
*** As to the exit sequencing, despite some communication miscues last month from a National Central Bank governor, the plan has been and continues to be to end QE first and then to raise the policy rate from its current 0.4% negative deposit rate. While theoretically possible to hike rates while still tapering or even before the taper starts, ECB officials do not see the logic in hiking rates at the short end and potentially “de-anchoring” the yield curve while still easing conditions on the long end – and markets often forget that “tapering” bond purchases represents a slowing in the pace of accommodation, not an outright tightening. ***
*** Under that plan, and barring a truly massive shock and deviation from the ECB inflation and growth forecasts, we believe there is effectively a zero chance the deposit rate will be hiked this year. We expect the most likely timeline for the QE taper and hikes — which granted is based on assumptions made well into the future — is for a taper of the 60 billion Euro QE program to begin at the beginning of 2018, at a rate perhaps of 10 to 15 billion Euros per month, which would put the end of the QE program and earliest likely date for a rate hike in April or June of 2018. The exact pace of course will depend on the economic outlook for growth and inflation at the time. ***
There has nevertheless been some speculation in markets that the ECB could bring forward and explain a hike in the negative deposit rate before ending the QE program as a “normalization” from emergency, sub-zero levels, and not an actual hike. But ECB officials push back on this notion, and maintain that a move back to zero is a tightening, no matter how it is sold.
Some big banks are also pressuring the ECB to reverse negative rates more quickly. But as the deposit rate is considered by ECB officials to be the anchor to the yield curve, even if its removal were to help some large banks, a de-anchoring of the curve and volatility in the long end would spell a disaster to the smaller banks, Sparkassen, and savings banks, a risk the ECB does not want to needlessly take.
But that does not mean that there has been no change at all to the exit strategy. To reflect some of those changes, and give itself addition room to maneuver, one of the anchors of forward guidance that we understand is sure to change will be language that the ECB expects interest rates will stay “at present or lower levels for an extended period of time, and well past the horizon of our net asset purchases,” (italics added).
At the last Governing Council meeting, ECB President Mario Draghi effectively neutered the downside directionality both on asset purchases and rates, in effect the “low or lower” language on rates, even though the formal guidance was unchanged, conceding that at this point the Governing Council no longer expected for rates to be cut further from here, or for the QE program to be expanded. Changing that language at this point is merely pro forma.
More interesting to markets now will be the shift in language on the timing of rate hikes, namely that they will come “well past the horizon of asset purchases.” We expect the “well past” guidance will come out or be modified as early as June as the ECB looks to give itself more flexibility now that it is finally looking at an exit strategy and eventual rate hike cycle, even if still well into the distant future.
The Economic Outlook
In regards to the economic outlook that is the ultimate underlying driver this policy sequencing, Draghi tomorrow will temper a broadly positive outlook for growth and inflation by stressing that inflation is still not seen to be sustainable without significant monetary accommodation.
He will caution not to get carried away too much by recent upbeat inflation numbers, in that much of the year-to-year pop in headline inflation that was due to rising energy prices is likely to dissipate. And while there may be some upside risk and revision to the ECB’s outlook for growth in the first half of this year, which it believes has been “firming and broadening,” there is still a potential downside risk to inflation in the second half and beyond.
Having said that, Draghi and his colleagues have a great deal to be pleased about.
For starters, deflation fears and risks are in effect all but gone, even though underlying price pressures remain subdued. Economic growth and the recovery has clearly been gaining momentum. And while there is still a gap between the positive survey data and numbers, that gap has narrowed, and is, for example, not as large as the gap seen in the US; looking ahead, the hard data are expected to confirm these positive sentiment indicators.
Furthermore, growth is not only firming, but is increasingly broad-based throughout the Eurozone. And for the first time it is being driven largely by domestic demand, and is not as reliant on exports as in the past. Both export and domestic demand for capital goods have been picking up. Labor reforms are paying off in southern countries, led by Spain, and inflation differentials, likewise, have been narrowing between north and south.
Household incomes are good, even though wage growth has been tepid. But even there, with employment stronger, more net jobs and incomes have been offsetting the weak wage growth. Indeed, the propensity to consume is higher from new jobs than wage hikes.
So even though oil prices have been rising, spending has not fallen. Savings have been stable or, if anything, going down a bit. And fiscal policy has been broadly neutral, after years of brutal consolidation.
Having said that, the ECB expects the output gap to be closed in two years, but only because of an incredible collapse in bank lending, growth, and potential growth that started in 2007.
To put that in context, surveyed growth expectations six to ten years out for the Eurozone were 2.25% back in 2003. That has fallen to less than 1.25%, and not recovered, despite a small blip up to 1.4% in 2012.
Key Policy Question Going Forward
The key question for the Governing Council in calibrating its exit strategy going forward will therefore be how much of the current recovery is truly self-sustaining, or still dependent on the five years of extreme accommodation?
Against the current backdrop of economic and inflation outlook, even assuming political risk does not escalate, the ECB is still unable to adjust policy until it is more confident an escape velocity to recovery has been reached and is no longer needing such accommodation.
But that should all change by the end of the year, when the current QE program is set to expire. And the ECB will start by signaling a change in its forward policy guidance at least six months in advance.