Draghi increases likelihood of further easing

ECB President Mario Draghi held a dovish speech at the Jackson Hole on Friday evening and the probability of more easing from the ECB has increased (see speech). In light of this, we expect it to be supportive for both periphery and core markets this morning. If the market deems the words as credible it will also put upward pressure on market-based inflation expectations, but it might require easing (QE) or higher actual inflation prints.

In the speech, Draghi indicated that medium-term inflation expectations are less anchored: ‘Over the month of August, financial markets have indicated that inflation expectations exhibited significant declines at all horizons. The 5year/5year swap rate declined by 15 basis points to just below 2% - this is the metric that we usually use for defining medium term inflation’.

In relation to this, Draghi hinted at broad-based QE, as he said, ‘the Governing Council will acknowledge these developments and within its mandate will use all the available instruments needed to ensure price stability over the medium term’ and ‘we stand ready to adjust our policy stance further’. Compared with previous comments about QE, it seems to be closer as the sentence ‘should it become necessary’ was excluded (see the comparison below). In line with that, earlier this year Draghi said that a worsening of the medium-term outlook for inflation would be the context for a more broad-based asset purchase programme (see speech).

Overall broad-based QE from the ECB seems to have moved closer, but the question is when the majority of the Governing Council supports it. We still believe the bar is high as it is more complicated to do QE within the euro area. Moreover, yields are already very low and the impact on the economy should be smaller than in the US as the economy is based on the bank lending channel and not on capital markets.

Interestingly, Draghi’s speech was updated with new comments on inflation made during delivery. This could reflect that Draghi has become more concerned after inflation expectations have continued lower recently or it could reflect Draghi’s own stance, which might be more dovish than the rest of the Governing Council, or perhaps it was a slip of the tongue. We believe Draghi is trying to talk inflation expectations higher.

Draghi has previously given dovish comments that were supported by the Governing Council later. In summer 2012, Draghi’s ‘whatever it takes’ led to the OMT programme and ahead of the upcoming ECB meeting in September, any support or back tracking from other ECB members will be followed closely. (This week only Liikanen is scheduled to speak).

So far, we maintain our view that the ECB will remain on hold in September unless inflation expectations decline further. Overall, we believe the ECB would like to see the first take on the TLTRO to get a better idea of the macroeconomic impact before easing again. However, a new cycle-low in inflation (released on Friday) could result in lower inflation expectations, which would make it difficult for Draghi to reiterate that ‘inflation expectations are firmly anchored’. We expect a very dovish stance in September, which is also needed to avoid a disappointment.