As expected, the ECB left rates unchanged, but the tone was less dovish than expected, and failed to reassure markets…..
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The ECB projects inflation closer to 1.0% than 2.0% also in 2015 l, but revised upwards 2014 GDP growth forecast. For the first time, the ECB also disclosed estimates for core inflation, which is shown rising and hovering above the headline index in 2014-15. Draghi reaffirmed forward guidance, yet “judged the inflation buffer as adequate”.
Indeed the ECB only briefly discussed a cut of the deposit rate cut, but beyond that has not identified “any specific instruments” within the ample array at its disposal. The likeliest scenario is of rates on hold at least until the 2015H2. Should the mild recovery scenario not materialize the ECB could cut the deposit rate in negative territory and may try to enhance forward guidance.
Another LTRO seems unlikely, as the ECB doubts it would spur lending. A QE remains a remote event. As widely expected, ECB left rates unchanged but the tone was less dovish than expected. The ECB confirmed, as fully justified, the November decision to cut rates by 25 bp, which we know was taken despite the opposition of 6 members out of 23. In December, the ECB only briefly discussed a deposit rate cut, beyond that “no specific instruments were identified” within the ample array of powerful tools it has at its disposal. Draghi declined to detail further on possible future actions should the contingencies materialize.
The news in the December statement is that the ECB now thinks that “a prolonged period of low inflation could be followed by a gradual upward movement towards inflation rates below but close to 2%”. The statement is supported by the new ECB staff projections, which also feature for the first time point forecasts for core inflation. Surprisingly 2014 GDP growth was revised upwards to +1.1% in 2014 (two tenths above November Consensus forecast), for 2015 the ECB sees a pickup in growth to 1,5%. As expected the ECB sees inflation closer to 1.0% than to 2.0%, also in 2015 (1.3%, from 1.1% in 2014). Surprisingly, the staff projects core inflation excluding (food and energy) above the headline index, both in 2015 and 2015, despite labour costs falling to 0,9% -1,0% in 2014-2015 from 1,4% this year. The ECB also published punctual estimates for the unemployment rate (11.8% in 2015, from 12% in 2014) and public finance balances. The staff projections suggest inflation dynamic is little if at all affected by the cyclical position of the EA economy and the decline in annual price dynamics is largely explained by the volatile food and energy components.
The ECB, however, still considers risk to growth as skewed to the downside, and risks to inflation as balanced. Therefore, the ECBi reaffirmed its forward guidance. During the press conference Draghi also stressed the November decision to extend full allotment until July 2015, as if to indicate that rates will stay at their present levels, or lower, at least until that date. However, Draghi’s rhetoric does not seem to have fully convinced markets. First of all, the President emphatically and more than once stressed that the exchange rate is not a monetary policy target. Also, Draghi judged as adequate the “inflation buffer”, based on evidence of core inflation gradually drifting higher, and given that the monetary policy impulse is transmitted with a lag, all the more so in a fragmented interbank market, and with balance sheet restructuring still under way in a number of European member countries. As if this were not enough, Draghi repeatedly said that, beyond a brief discussion on cutting the deposit rate, the ECB Council did not identify specific instruments within the wide range available to it. Regarding liquidity operations, Draghi indicated that the decision to use long-term operations in 2011/2012 was prompted by the high levels of uncertainty and volatility on the markets at the time, and observed that the main effect of the measure was to generate profitable carry on government bonds. Today, uncertainty has eased, but it is by no means a given that the extra liquidity would be used to step up the offer of credit. Draghi stressed that the AQR could have a much stronger impact in restoring confidence in European banking system, and on lending.
What should we expect in 2014?
Draghi’s less tone, together with core inflation estimates above headline, suggests that the ECB thinks that its past actions might be enough to counter to ensure consumer price dynamics moves back towards the 2% target and that forward guidance is an adequate enough instrument to keep short-term rates under control. Let’s hope that the Fed’s tapering process doesn’t prove the ECB was too optimistic on its capability to steer markets with words.
Our main case scenario is of rates on hold well until the second half of 2015. Yet, it could well be that the ECB finds itself in the position to do more in 2014: the rebalancing process is still lengthy and could prove more severe than generally assumed. If data suggested downside risks to the macro scenario, the ECB could trim the deposit rate into negative territory. In addition, it could try to enhance forward guidance.
Another LTRO seems less likely, in the wake of the December meeting communication and unless the ECB finds a way to tie liquidity provision to the supply of credit. Last but not least we continue to think that QE remain a remote event in Europe, given also the opposition it would face within the Governing Council.
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