Will the ECB cross the Rubicon?

Declining inflation expectations raised expectation on more ECB action

Draghi suggests more needs to be done

Small repo-rate cut to enhance attractiveness TLTRO tenders possible

Announcement on some sort of ABS buying programme likely

Broad-based QE purchase programme highly unlikely

Risks are for a disappointment in bond market, following recent bull run.

At the June meeting, the ECB took important decisions like the lowering of its official rates, including the lowering of the deposit rate into negative territory and the announcement of TLTRO tenders that will be held starting this month. The ECB clearly thought these decisions would clear the horizon for at least the remainder of the year. Three months later, the ECB is under pressure to act again. The EMU recovery is faltering, inflation dropped further and inflation expectations showed tendencies to become de‐anchored. At the Jackson Hole symposium, Mr. Draghi himself opened the door for eventual additional ECB easing steps. However, it remains unclear which measures it would eventually take and when. Before tackling these questions, we briefly give an overview the recent developments and summarize the essence of Mr. Draghi’s speech.

Economic recovery falters, inflation eases further

The EMU economy stagnated in Q2, following a modest 0.2% Q/Q increase in Q1. On a yearly basis, growth slowed to 0.7% in Q2 from 0.9% previously. The German economy, erstwhile the motor of the euro area, contracted by 0.2% Q/Q, while the other heavyweight France reported no growth in Q1 (up 0.1% Y/Y), while Italy, the third biggest euro country, slid again into recession, the third one in 6 years. While the German contraction in Q2 followed a strong Q1, Q3 will probably show little improvement. Indeed, monthly data from Germany and from the euro area as a whole suggest that the growth momentum is fading. So, the early year expectations that the euro area was staging a sustained, if modest, recovery have evaporated. The conflict in Ukraine has had a bigger than expected impact, even if the slowdown cannot be fully explained by the effect of sanctions and geopolitical uncertainties.

The monthly euro area sentiment data for July and August (PMi’s and EC eco sentiment) confirm the euro area recovery has passed its peak and might now have entered a downturn. The exact nature of this downturn is as yet not known, but in the context of the sharp loss of output during the financial and euro crisis of past years, this fading momentum is “politically” unacceptable. While unemployment data have improved now for about a year in lockstep with some the improvement in the economy, the July data showed the first rise in unemployment in a year. Given the lagging nature of the labour market developments, this doesn’t bode well for the next quarters.

In the past months, euro area inflation has continued to fall. According to the flash estimate, inflation dropped to 0.3% Y/Y in August, down from 0.4% Y/Y in July and 0.5% Y/Y in June. Admittedly, in recent months, the decline in inflation was driven by volatile food and energy prices. Core inflation even ticked higher to 0.9% Y/Y in August from 0.8% Y/Y in June and July. However, this shouldn’t breed complacency. Core inflation is still near all‐time lows (0.7% Y/Y) and in a context of faltering growth, inflation may slow further. The effect of the cheaper euro on (higher) inflation may be partly neutralized by the decline in energy prices and the demand shortage.

Falling inflation expectations

The ECB is particularly concerned by the drop of inflation expectations in August, which suggests that the euro area may slide into a protracted period of (too low) inflation or even deflation. The ECB has always dismissed the danger of deflation by pointing to the well‐anchored inflation expectations. In August, the 5‐year/5‐year forward inflation expectations dropped to 1.95%, which incited Mario Draghi (see below) to consider this as loss of market confidence in the ability of the ECB to revive inflation. It might have prompted his dovish comments. Expectations veered slightly higher since, probably as a result of Draghi’s suggestion that the ECB may need to do more to support the economy and fight too low inflation. Mr. Draghi correctly pointed out that inflation expectations at shorter horizons declined still more significantly.

Door for additional policy easing open

In his speech on the labour market at the Jackson Hole symposium, Mario Draghi clearly broke new ground. He called for fiscal policy to play a greater role alongside monetary policy in order to boost economic growth, fight unemployment and push inflation higher. He asked fiscal policymakers to use all the flexibility the Stability Pact allowed, suggested that some countries, without fiscal shortcomings, might be fiscally more accommodative and saw opportunities for more accommodation at the level of the union. Of course, Draghi does not have the power to set fiscal policy and it remains to be seen whether European policymakers have the political will to take bold action. It is no secret that German policymakers are not ready to ease their fiscal policy and do not want EMU deficit countries to flout the rules of the Stability Pact.

However, Mr. Draghi is responsible for monetary policy and on this subject his remarks carry weight. He said that the ECB was not out of ammunition and had a role to play in supporting insufficient demand. Those comments echoed throughout the markets and raised expectations for a further easing of monetary policy. Besides his call to fiscal policymakers, at least three other elements supported these expectations. His admission of the de‐anchorage of inflation expectations, of the limitations of policy due to the zero bound issue and his observation that the risks of doing too little outweighed those of doing too much.

He remained vague on the timing and the nature of additional easing, but his remarks suggested the possibility that the ECB would not wait too long. Many analysts and traders are looking for measures to be announced as soon as Thursday.

What to expect from ECB?

Regarding the nature of ECB action, markets envisage various possibilities. Some think rates will be cut again, some expect an announcement on ABS buying, while others already look for a broad‐based QE programme (of buying sovereign bonds).

In Spring, Mr. Draghi elaborated on three contingencies which could trigger an ECB response and on the instruments to be used in these situations.

Small chance of repo rate cut to support TLTRO

First, if there is an unwarranted tightening of monetary conditions the ECB would use its conventional policy tools, notably interest rates. Such tightening might be the result of a strengthening of the euro or an increase in money market rates due to diminished liquidity. However since June, the euro has weakened, money rates are stable near zero and bond markets rallied in core and peripheral euro area countries. Thus, monetary conditions have eased, not tightened. So, along this reasoning, the ECB might not change its official policy rates as many observers expect. On top of the first argument, pushing the deposit rate further down in negative territory may bring money market funds in problems and make the funding of banks more difficult. Of course, the ECB may cut its repo‐rate and keep the depo‐rate unchanged, narrowing the band within which money rates traditionally fluctuate. This would make the TLTROs more attractive for banks and thus secure a bigger take‐up. The TLTRO is priced on the repo (15 bps) plus 10 basis points. The decline in 4‐year yields (duration TLTROs) in past months have diminished the attractiveness of this TLTRO pricing to some extent. The ECB clearly wants the TLTROs to be a big success, as it would address the cliffissue when the 3‐year LTRO’s expire early 2015 and secure sufficient excess liquidity is available to keep money rates at very low and stable levels. So, while we think that a reporate cut is possible, we see only modest chances of it happening. Its impact on overall markets would be rather limited.

TLTROS to be implemented as planned

Second, the ECB may react if the transmission mechanism is impaired. That remains the case, but the TLTROs announced in June and to be implemented later this month, are the tool the ECB provides for this contingency. Mr. Draghi still expects the TLTROs to contribute to further credit easing. It would be a bit odd to announce a new initiative to address deficiencies in the transmission mechanism before the TLTROs are effectively implemented.

ABS announcement?

Third, in case exogenous and endogenous factors would push the euro area in a persistent regime of excessively low inflation (or deflation), the ECB would react by a broad‐based purchase programme. Recent developments suggest that such a contingency may be materializing and Draghi’s hint of action concerns such a QE programme. In his speech, Draghi indeed said that preparations for outright purchases in ABS markets are fast moving forward. Last week, the ECB announced that it had engaged Blackrock as a consultant for such a (private) QE programme. So, it is possible that the ECB will announce on Thursday the implementation of such a programme, even if its actual implementation may still take some time. Indeed, in an interview, ECB Coeure suggested that a number of obstacles still exist to revive the ABS market. In its current form, the ABS market seems inapt to implement a broad‐based purchase programme. Of course, maybe the ECB wants to take a slow start.

Some observers think that the ECB may announce the start of a broad‐based QE (sovereign debt) purchase programme, but we think this is unlikely. Such a programme still meets a lot of resistance inside the ECB Council and in some euro countries. It doesn’t fit well with at least the spirit of the Treaty. It might be decided later on, if and when the TLTRO and the ABS buying would prove to be insufficient. Starting it now before implementing both other programmes looks odd.

Risks on disappointment prevail.

In conclusion, we might see a small repo‐rate cut to raise the attractiveness of the TLTRO and an announcement on ABS (private QE) buying. For a broad‐based QE programme, it looks way too early. Mr. Draghi’s speech at Jackson Hole has raised expectations that the ECB will soon take bold action to fight the risk of deflation. By raising the expectations, there is the risk of disappointment if Draghi doesn’t deliver. It is not excluded that the Governing Council wants to go slower than Mr. Draghi. Indeed, there remain a lot of questions about the merits of QE. In particular, we will closely listen to the comments of Mr. Draghi at the press conference. Will he repeat that inflation expectations are de‐anchored and that doing too much is better than doing too little? Will he repeat his appeal for a more accommodative fiscal policy? Of course, the new staff forecasts for growth and inflation will colour Draghi’s comments.

So, uncertainties about the outcome of the meeting are maybe higher than ever. Risks for disappointment prevail, we think, following the steep decline in yields in past weeks.