ECB preview: The balance is set to tilt to more easing

• We see the odds slightly in favour of further ECB easing this week. The Governing Council has discussed more easing at the latest ECB meetings and we think the balance will tilt this time. Our main scenario is a small refi rate cut to 0.15%.

• This follows mainly as inflation fell to a new cycle-low of 0.5% in March. The decline implies that the ECB’s projection for inflation, which was released a month ago, is already too optimistic.

• Another important argument for easing is that nominal wage growth declined in Q4. It is now around the level in 2009, when the financial crisis was at its worst. This could be a first signal of second-round effects, which is a concern for the ECB.

• On the other hand, the recovery looks to remain on track and most other data including economic indicators and data for monetary development have not deteriorated since the latest ECB meeting. Hence, it is a close call.

• If the ECB once again abstains from easing, we expect Draghi to sound dovish, but there will initially be a small disappointment and rates will inch higher. The markets will at some point get enough of soft words and instead demand action.

• In short-end EUR markets lots of dovish ECB talk has raised expectations of more easing and the EONIA curve is inverse again. If the ECB lowers the refi rate it will lead to marginally lower rates out to two years as more easing will be priced in.

ECB set to ease in April as inflation is at a new-cycle low

Euro inflation was down at a new-cycle low of 0.5% in March and we see the odds slightly in favour of the ECB easing at the meeting this week. It is a close call and there is a fairly high risk that Draghi will describe the low inflation print as related to the decline in commodity prices and technical owing to the timing of Easter. However, the ECB might not ignore the first as it has argued that “longer-lasting supply shocks may have a systematic impact on inflation and could affect inflation expectations, meaning that monetary policy should respond to them”. Moreover, inflation is already below the ECB’s forecast, which was released a month ago and which was revised down to the limit of Draghi’s definition of the inflation ‘danger zone’ of 1.0% for 2014. Hence, although it is a close call, we do not expect the ECB to wait for another negative surprise, but we believe it will see inflation at 0.5% as too far from the 2% target to abstain from easing again.

Wage growth down near the level in 2009

Another very important argument for the ECB not to remain reluctant again is that wage growth declined to 1.4% y/y in Q4 from 1.7% y/y in Q3. This is around the level in 2009 when the financial crisis was at its worst. The decline could be the first signal of secondround effects, where wage growth goes lower as it reacts with a lag when inflation is pulled by commodity prices. In this scenario, wage setters are willing to accept lower wage increases because the lower inflation gives support to real wage growth.

The decline in wage growth seems to have surprised the ECB, as its projection for wage growth in 2013 now appears too high. The sign of second-round effects is a concern for the ECB and Bundesbank President Jens Weidmann has related to the declined in food and energy price inflation recently said, that “it is my conviction that monetary policy should respond to such factors only in the case of second-round effects”. The decline also implies that the ECB’s expectation that core inflation will rise quite a lot in 2014-15 looks optimistic and in our view lower wage growth is an important argument for more easing.

The fall in wage growth to some extent also illustrates that the ECB cannot continue to remain complacent regarding inflation expectations. This follows as wage setters use short-term rather than long-term inflation expectations to set wage demands for the next one-two years. Up until now, the ECB has argued that inflation expectations remain anchored, which mainly follows as the ECB’s survey of professional forecasters still shows that long term inflation expectations are anchored at 1.9%. Nevertheless, one and two-year inflation expectations together with market based expectations are historically low excluding 2009.

Right before the latest ECB meeting the IMF pointed out that it can be dangerous to use long-term inflation expectations in judging the anchor for inflation. The Japanese case suggests that one should focus on short-term inflation expectations as long-term inflation expectations in Japan did not fall ahead of the deflation.

In the absence of more easing from the ECB there is a risk that longer-term inflation expectations will be de-anchored as inflation is expected to stay below the ECB’s target.