ECB confident its programme will work

ECB now in “implementation” mode with QE set to start March 9

New Staff projections show growth and inflation sharply revised higher

ECB sees very strong recovery taking hold through next couple of years

QE to bring inflation to target by 2017, suggest QE to end by Sept 2016

Draghi acknowledges “complexities’ in bond buying but downplays practical constraints; Will ECB find sellers? -0.2% is floor

Limited upside yields and euro

As the ECB had already taken the bold step of committing to an Asset Purchase Programme at its January policy meeting, there was little anticipation of any dramatic pronouncements from the governing council meeting.
However, markets were reassured by the confidence and clarity of comments from ECB president, Mario Draghi.

There was further significant clarification as to the practicalities of the Asset Purchase programme, now titled the Public Sector Purchase Programme (PSPP). In addition, the ECB’s new economic projections suggest a considerable measure of confidence in Frankfurt that the PSPP can deliver a marked improvement in the trajectories of both activity and inflation in the Euro area. In turn, this hints the programme might be expected to terminate in September 2016.

The ECB press conference was relatively low key. With major policy action only recently announced and some encouraging if still tentative signs of late in relation to economic growth and inflation, it was not surprising that pressure on Mr Draghi has eased ‐ at least for now.

Attention as the opening press statement noted has now shifted from what might be done to how it will be done; ‘the focus is now on implementation’. The statement also indicated that bond purchases would begin on March 9th.

After a slightly jumpy few minutes as markets digested the message from the ECB, there was a marginal easing in the exchange rate of the Euro and in Eurozone bond yields, an outcome that implies traders believe accommodative ECB action will continue to limit the upside both for the currency and interest rates. In the near term that does not seem an unreasonable expectation but the new ECB projections suggest a marked improvement in economic conditions will take hold through the next year or two. This hints at a possibly significant future correction in either ECB projections or market pricing.

New ECB Projections Suggest Confidence QE Will Work

It was inevitable that the new ECB projections would entail notable alterations from the previous estimates published in early December. Recent data suggest activity was not as weak as feared over the turn of the year and lower oil prices and a weaker exchange rate will add to momentum for 2015. As a result, the new estimate for GDP growth this year has been raised from 1.0% to 1.5%. Significantly, a broadly similar upward revision has been made to the forecast for 2016 which now envisages growth of 1.9% compared to 1.5% three months ago.

ECB Confident QE Will Boost Euro Area Recovery and Push Inflation Close To 2%

The ECB sees even faster growth in 2017, with real GDP increasing 2.1%. This would mark the fastest outturn since 2007 and would be about twice the estimated potential growth rate of the Euro area. This pick‐up in growth also occurs against a backdrop of technical assumptions that entail modestly higher oil prices and interest rates and a flat exchange rate.

The ECB notes ’the risks surrounding the economic outlook for the Euro area remain on the downside but have diminished following recent monetary policy decisions and the fall in oil prices’. However, the new projections for activity imply an altogether more upbeat judgement than this phrase might imply. In effect, they suggest the Euro area economy will move onto a fairly strong growth trajectory and make up some element of the ground lost in recent years. That said, the relatively modest drop envisaged in the unemployment rate—to 9.9% in 2017— suggests that the Euro area economy should still remain some distance from overheating conditions.

Much lower than expected inflation over the turn of the year means the ECB’S new projections entail a notably lower forecast for inflation in 2015 (from 0.7% to 0.0%). A more notable aspect of the new projections is the upward revision to the projection for 2016 from 1.3% to 1.5% that reflects a marked improvement in activity coupled with some modest increase in energy costs. Far and away, the most significant element of the new projections is that the ECB’s initial inflation estimate for 2017 is 1.8%, effectively reaching its stated target of an outturn of ‘below, but close to, 2%’.
This marks the first time the ECB envisaged an outcome in the region of its target for several years.

How Quickly Might QE End?

.Importantly, an envisaged inflation outturn of around 1.8% would seem to correspond to the definition of ‘a sustained adjustment in the path of inflation’. In turn, that would imply the goal of the asset purchase programme would be achieved, thereby allowing the programme to be ended.
With inflation, currently at ‐0.3%, there is still some considerable distance to travel along this path but if the projection of 1.5% envisaged for 2016 begins to look reasonable in early 2016, we might be far enough along the inflation ’path’ to suggest that the asset purchase programme would conclude in September of next year.

Of course, if inflation were to surprise significantly to the upside in the interim, market thinking could turn to the possibility of an earlier termination. In that event, the focus might quickly switch to what exactly is meant by the ECB’s indication of an ‘intended’ end date no earlier than September 2016 and how different this might be from a full commitment to continue to that point.

We think that the new ECB projections are intended to firmly signal’ as Mr Draghi indicated, that ‘the monetary policy decisions we are discussing today are final set of a series of measures’ and that the ECB fully expects them to be successful notwithstanding some uncertainty about the likely effectiveness of such unconventional measures. We would highlight potentially significant differences of opinion as to whether the new projections are too optimistic or too pessimistic in relation to the likely trajectory of the Eurozone economy (and the impact of the asset purchase programme on that trajectory) through the next year or two.

The detailed note accompanying the new projections states that ‘the additional impact of these measures via financial transmission channels, such as portfolio balancing channel, certain expectations channels and real‐financial feedback loops’ has been included in the projections. Our sense is that this hints at a surprising degree of confidence in the capacity to precisely quantify the impact of previously untested policy interventions. Of course, it is likely that the scale of asset purchase programme decided upon was based on similar calculations. So, it is not entirely surprising that relatively healthy projections ensue.

Some Further Guidance On How QE Will Work But Key Questions Remain

While the new projections provide a picture of what PSPP may deliver in terms of economic outcomes, markets were also keen to get additional information on how it might operate in practice. As noted above, the programme will commence on March 9th and will entail National Central Banks of the Eurosystem focusing exclusively on their home market although this allows some discretion to purchase the debt of agencies established in their jurisdiction. While there will be some flexibility in terms of the volume of monthly purchases, the ECB’s capital key will ‘guide’ monthly purchases by National Central Banks. The intention is to be market neutral in terms of maturities purchased (within the previously announced 2 to 30 year maturity window) but some flexibility will be allowed to reflect liquidity differences between maturity segments.

Mr Draghi also announced that the ECB would purchase bonds with a negative interest rate out to the ECB’S deposit rate which stands at ‐0.2%. The key question is how compressed the spread between different maturities and different issuers becomes as the ECB rolls out its purchase programme. In the early stages at least, this will be determined by the ease with which the ECB finds ready sellers in various segments.

While Mr Draghi acknowledged some ‘complexities’ might arise, he suggested that the ECB did not see major issues in this regard. His indication that about half of Euro area bond holdings are held outside the Euro hinted that these holders might be more ready sellers than Euro area institutions. Our sense is that in the very early stages the ECB should be able to report a significant take‐up of its offers but the thinness of many segments coupled with still limited alternative demands for funds may pose problems as the year progresses.