ECB to take difficult decisions

Momentum for a policy change slowed in recent days, but..

….decision will remain finely balanced, as

….inflation is too low and staff projections might see little change until 2016.

So, a refi-rate cut and even negative deposit rate remain possibilities

At the February ECB meeting, policy was kept unchanged. During the press conference President Draghi said that there had been a broad discussion that focussed on the need for additional information because of the present uncertainty. He announced that in March the ECB staff projections would include forecasts to 2016, a far earlier public release of two year ahead forecasts than previously. This suggests that the 2016 inflation projection will be a crucial element in the ECB deliberations on Thursday. After the G‐20 meeting, Mr. Draghi further emphasised the importance of these new projections, saying The council will have the full set of information needed for deciding whether to act or not by its next ECB council meeting at March 6, including the staff forecasts for 2016”. Below, we briefly describe the most relevant recent developments on the economy before discussing our expectations for the new projections and setting out our thoughts on the upcoming ECB policy decision.

Recovery on track, but fragile

Preliminary estimates show Q4 2013 GDP was up 0.3% Q/Q and 0.5% Y/Y, slightly exceeding expectations and up from 0.1% Q/Q and ‐0.3% Y/Y in Q3 of 2013. So, some recovery in activity is confirmed and the growth pace, while remaining slow, quickened a bit. The February PMI business confidence was mixed and slightly disappointing. It suggests however that the recovery remains on track, but there is little indication that it is building any major momentum. Manufacturing PMI index dropped to 53.2 from 54 in January, while the services PMI more or less stabilized at 51.7. EC confidence data more or less confirmed the mixed message from the PMI. Concluding, the economic picture didn’t change substantially in the past month and to use one of Mr. Draghi’s often used description: the recovery is ongoing, but uneven and fragile. Two risks are obvious. The geopolitical tensions surrounding Ukraine may escalate, but for now its effects should be contained. Secondly, the US economy slowed quite substantially at the start of the year, but it is unclear how much of the slowing is due to the, temporary, effect of bad weather. We expect that it will take a couple of months before it is clear whether these developments are having any significant impact on the European economy. However, at the margin, both further increase the downside risks to economic activity long noted by Mr Draghi.

In the past, the ECB wouldn’t ease policy when the economy had started to recover. Analysis clearly shows that the inflation cycle lags the business cycle. So, forward looking central bankers react primarily to business cycle developments as their policy decisions only impact the economy with a time‐lag. This is illustrated in graph 1 which relates all (pre‐Draghi) ECB rate changes to growth (proxied by manufacturing PMI on the horizontal axis) and inflation (vertical axis). Actual inflation indeed plays no big role in the timing of interest rate decisions. Regarding the rate changes, in the pre‐ Draghi era, rate increases were decided with a 50+ PMI reading and cuts when PMI’s were below 50. Since Mr. Draghi became ECB president a lot changed in policymaking, convincing us to argue some months ago that the ECB DNA (and reaction function) had changed.

The November 2013 rate cut happened when the PMI was well above 50 (see graph 2) and if the ECB would ease policy again, it would be a second deviation from the past reaction function. Not only ECB policymaking has changed, but so has the behaviour of the economy and inflation. The financial crisis impacted the economy profoundly, suggesting that slack might be much bigger than before, but also inflation may behave differently.
Disinflation is a global phenomenon, even in the US whose growth performance has been not so weak in recent years. Mr. Draghi is much more activist than his predecessors and knows that too low inflation for too long may in combination by an unknown shock lead to deflation. Mr. Draghi as recently as yesterday stated: “We know the longer inflation stays at the current level, the higher will be the risk that it will not go back to 2% in any reasonable time. In other words, the longer will be the risk that inflation expectations could be dis‐anchored and we don’t want that”.

Once the economy slides into a deflationary context, it becomes very difficult to fight it successfully. As in most policy issues, prevention is far better than cure. If one adds the very fragile situation of the periphery, the potential downside of the turmoil in Ukraine and the context of excessive official and private debt load, Mr. Draghi may err on the side of caution and ease policy. We admit that pressure for a policy easing is ebbing a bit away in recent days, due to an upward surprise in the preliminary February inflation reading and a confirmation that the recovery remains on track. These developments may have increased uncertainty somewhat and made it more difficult to forge a consensus for immediate action. Therefore risks have increased that the ECB will stand put for now. Nevertheless, we think that risks for an additional easing of policy should not be underestimated. We review recent monetary and inflation evolutions before drawing on the arguments for an additional easing.

Inflation stabilizes at low levels

February HICP stabilized at 0.8% Y/Y, while core HICP rose to 1% Y/Y from 0.8% Y/Y previously. Markets, including us, expected headline HICP to have dropped to 0.7/0.6% Y/Y and core inflation to have stabilized at 0.8% following the release of the national inflation reports of Germany, Italy, Spain and Belgium. Inflation in these countries were all lower in Y/Y terms. This suggests that the French inflation, not yet released, has risen substantially from 0.6% Y/Y in January. The increase in VAT introduced in France in January had not impacted French inflation in January (0.6% Y/Y), but might have done so in February. We’ll know when the French national data are published. If the VAT was the main culprit it says little about underlying inflation tendencies and should provide a favourable base effect to inflation in early 2015. By the way, given the modest increase in French VAT, it is unlikely to have been the major reason for higher than expected inflation in February. This number clearly helped cool expectations the ECB would ease. Of course, we wouldn’t draw too much conclusions from this report. The bottom line is that headline inflation stabilized at 0.8% Y/Y, far below target and much too low for comfort. The rise in core CPI carries more weight, but probably isn’t pointing decisively towards any easing in downward pressures on inflation. It likely reflects timing issues as well as some impact from VAT increases.

In theory, one month’s slightly higher(core) inflation reading should have very little influence on Thursday’s policy decision. The ECB focuses on medium term inflation. When specifying its forward guidance, the ECB indicated that a downward revision of the medium term outlook for inflation would be a reason to ease policy further, in part because this would not reflect a shift in policy stance but merely action to avoid an unwarranted tightening of money market conditions. On the latter we won’t elaborate today, because these conditions are currently not fulfilled. Regarding the medium term inflation expectations, the December ECB staff put inflation at 1.1% in 2014 and 1.3% in 2015. Since, inflation has come out somewhat weaker suggesting that a minor downward revision of the 2014/15 projections would be appropriate. The EU recently projected inflation of 1% in 2014 and 1.3% in 2015. However, it looks like the 2016 inflation projection will be the key factor. If inflation is well off 2% even in 2016, it will be difficult for the ECB to stand aside. It would mean the ECB expect to miss its medium term inflation objective. The ECB has always stated that it interprets its inflation mandate in a symmetrical way. The survey of Professional Forecasters, conducted by the ECB in past weeks, puts 2016 inflation at 1.7%. One may discuss whether this is too far away from the 2% target to consider it a miss of the objective. However, anything below 1.7% might convince the ECB that more easing is needed. Graph 3 shows that the EMU economy has not yet recovered the production losses since the 2008 crisis. So, it is fair to say that there is still a lot of slack in the economy. The 12% unemployment rate only confirms that message. This means that wage growth will be subdued and underlying price prices will remain largely absent for the foreseeable future.

Differences between countries

Of course, this overall picture doesn’t exclude differences between various countries and more in particular between Germany and the periphery. The latter is only slowly recovering from a very deep end prolonged recession and still faces structural problems. However, the German economy is booming and spare capacity may be reducing. However, even in Germany, headline inflation is barely 1% Y/Y and, more worryingly, recent data from the statistical office show that wage growth is extremely slow, despite all headline news about stronger wage growth. In 2013, nominal wages rose 1.3%, which resulted in real wage growth of ‐0.2%. The figures for 2011 and 2012 were respectively 3.3% and 2.5% for nominal wage growth and 1.2% and 0.5% for real wage growth. In this context, it is clear that German domestic demand remains too weak to expect the German economy to play fully its role of locomotive for the whole euro area. it is also extremely difficult for peripheral countries to increase their competitiveness without lowering wages quite drastically. This is a recipe for low inflation for long, difficult adjustment in the periphery. However, it is wrong to see this issue solely in terms of ‘crisis’ economies. Countries like France and Italy also face significant difficulties. Finally, current very low levels of Euro area inflation raise risks for outright deflation if another external shock were to hit the euro area. As noted above, deflation is far more easily avoided than treated. So, merely stating the obvious that the euro area is not in deflation seems a very short‐sighted policy position to adopt. Concluding, the February inflation figures may have been higher than expected, they shouldn’t ease fears of too low inflation at the ECB. The disinflationary climate is also a phenomenon in all industrial countries. Inflation expectations (see graph) are still (just) within the ranges that held in the past 5 years, but unlike the US and UK, the expectations are downward oriented in the euro area.

ECB change of rhetoric

A number of ECB comments made us think that the ECB was preparing the markets during February for an eventual policy action. Mr. Draghi signalled after the G‐ 20 meeting that all information needed to take a decision would be on the table on Thursday. He also pointed to the risks of too low inflation for too long and the risk of de‐anchoring inflation expectations. ECB Coeuré, member of the ECB Executive Board, said “We are on alert to the notion that we are close to the region where a downside shift in our inflation path could bring us in dangerous areas” “Inflation expectations could be altered and create downside risks to price stability.” He also said that the ECB is considering negative deposit rate “very seriously”. ECB Praet said the ECB sees no risk of deflation, which is saying the obvious, but added “..but we admit that price pressures are weak and this weakness in price evolution extends to the medium term.” We were also struck by comments in the Bundesbank monthly report that they would be open to suspend the sterilization of the SMP bond purchases if more liquidity is needed. This surprises, as it is back‐door QE, something which the Bundesbank doesn’t like. We would see it, if adopted, as another step towards the introduction, in due time, of outright asset purchases. Bundesbank president Weidmann on the other hand was very critical on a negative deposit rate. It is not excluded that opening the possibility of non‐sterilization was a defensive move to kill the negative deposit option that was apparently gaining acceptance in ECB circles. Whatever, these manifold comments suggest that the ECB was indeed moving closer to a decision to take some further action. Of course, the February inflation report and signs the recovery continues may have influenced the debate that takes place Thursday.

What decision?

Chances on a policy change have diminished, but we don’t change at a late stage our expectation of a lowering of the repo‐rate to 10 basis points and of the deposit rate to ‐10 basis points. As too low inflation is the trigger for our expectation of a policy change, a rate cut is a clearer signal than for instance the nonsterilization of the SMP programme, which is a more technical measure more suite to address liquidity issues as well as being less well known in wider circles. The decline of the deposit rate is, we think, a good idea because it might weaken the euro. The FX transmission mechanism has a more direct effect on inflation than lower rates in a context of a still clogged interest rate transmission mechanism and deleveraging. Of course, given Bundesbank opposition to the latter, we don’t exclude an unchanged deposit rate coupled with the non‐sterilization decision. If the ECB decides not to cross the Rubicon now, it will keep its forward guidance including easing bias intact and president Draghi will sound soft, keeping alive the option of an easing at a later stage. In this context, market impact would remain limited anyway.