ECB more confident the worst has passed

• Lagarde still sounds cautious but less concerned about outlook.
• ECB more upbear than expected, implying a greater tolerance for a strong euro.
• New ECB projections see sustained upturn in growth but not a surge.
• Major surprise is a marginal upgrade to inflation outlook.
• Forecasts suggest no inclination towards early easing.

There was no expectation of major policy changes or that there would be any signalling of marked shifts in ECB thinking at yesterday's Governing Council meeting. However, the general tone of ECB comments delivered in the regular press conference given by ECB president, Lagarde, was a little more optimistic about the health of the EMU economy and even more so about the likelihood of a sustained if modest increase in inflation.

This more positive assessment of economic prospects might suggest that the bar for ECB easing may be somewhat higher than many in the market may have envisaged. It also implies that the ECB could be willing to tolerate a somewhat stronger Euro exchange rate. FX markets may probe the extent to which the Euro can rise without prompting ECB concerns.

ECB relieved at economic rebound

The opening lines of the ECB press statement not surprisingly continue to emphasise the ‘elevated uncertainty' in the current environment although this represents a marginal stepdown from the ‘exceptionally elevated' phrasing used in July . More generally, the ECB signalled increasing confidence in an emerging economic rebound, noting ‘The incoming data since our last monetary policy meeting in July suggest a strong rebound in activity'.

This marks a notable upgrade from the guarded acknowledgement of ‘a resumption of euro area economic activity' in the July statement, although the reality of this improvement likely comes as a relief rather than a surprise to the Governing Council, as the statement adds that these developments are ‘broadly in line with previous expectations'.

Recovery to remain modest

It should be recognised that increased optimism is primarily a reflection of the expectation of a somewhat smaller fall in GDP in 2020 now put at ‐8% from the previous ‐8.7% estimate and this, in turn, is primarily influenced by a smaller than feared downturn in the second quarter rather than a faster recovery over the remainder of the year. Moreover, there were marginal downward revisions to projections for GDP growth in 2021 (+5.0% v +5.2%) and 2022 (+3.2% v +3.3%). So, changes in the new projections largely reflect the fact that the Euro area's recent past (in GDP terms) was not as bad as had been feared rather than a sense that the future might be better than previously hoped.Contrary to widespread expectations, the outlook for inflation was revised up marginally (for 2021) rather than down across the entire projection period. Inflation is nevertheless expected to be very modest and well below the ECB's target throughout the projection period.

With growth expectations unchanged, unit labour costs marginally more subdued than was envisaged previously and the exchange rate of the Euro seen materially stronger (about 3% higher in 2022 and 2023), it is somewhat surprising that headline Euro area inflation is higher than previously projected in 2021 (1.0% v 0.8%) and ‘core' inflation is seen higher in both 2021 (0.9% v 0.7%) and 2022 (1.1% v 0.9%). The ECB suggests this may be driven by increased profit margins on firm exits presumably reducing competition in the post pandemic world as well as indirect effects of higher oil prices.

It is generally expected that in time inflation will pick up materially from the ‐0.2% reading recorded for August. However, in circumstances where pricing powers are likely to remain limited and, at the margin, exchange rate strength will also be a constraining factor, it seemed more likely that the new ECB projections would have seen the inflation outlook marked down rather than up.

No further easing envisaged ...for now?

The combination of increased optimism or, perhaps more correctly, reduced nervousness about the growth outlook and the prospect of a slow but sustained pick‐up in inflation would remove one potential source of pressure on the ECB to ease policy further. However, the likelihood is that such pressures will build in coming months.

The ECB'S chief economist, Philip Lane recently emphasised two stages in the challenge now facing monetary policy. The first comprises an aggressive emergency response while the second seeks to calibrate policy settings to ensure a return to an equilibrium encompassing inflation at the ECB's target.

The likelihood is that the ECB feels it is now close to completing the first part of this process but it may be too early to attempt to assess‐ or, more significantly, to find a consensus among ECB Governing council members‐ as to what precise policy settings are required to put the economy back on a strong and sustainable recovery path.

In these circumstances, a key consideration is not to allow policy setting become distracted by developments such as exchange rate movements that either could prove to be temporary and unimportant or, alternatively, might reflect equilibrium changes that monetary can't properly correct. This is not to suggest the ECB is ignoring the exchange rate but it does suggest its importance at least for the moment is notably reduced by the exceptional nature of current circumstances.

Euro strength not an issue for the ECB?

The ECB did include a tepid reference to the exchange rate in the opening press statement, noting, ‘in the current environment of elevated uncertainty, the Governing Council will carefully assess incoming information, including developments in the exchange rate, with regard to its implications for the medium‐term inflation outlook.'

In response to repeated questioning, ECB president, Christine Lagarde, also acknowledged that it had been discussed ‘extensively' by the Governing council and, while ‘not a policy target', it is ‘an important determinant of price setting'.

Our sense is that FX markets may seek to test the ECB's tolerance for a stronger exchange rate. The initial response is likely to be repeated if irregular verbal intervention by ECB officials but this approach is quite quickly to suffer diminishing returns.

With the US Federal Reserve recently having signalled an average inflation target that implies lower US rates for notably longer as well as hinting at a further easing in coming months, perceived differences in central bank stances may mean the Euro/dollar exchange rate could become a focal point for markets.

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