10bp cut in deposit rate and extension of bond buying notably less than hinted at.

Markets react sharply as interest rates and Euro exchange rate rise significantly.

Latest ECB projections largely unchanged as downside risks haven’t materialised--thereby justifying smaller easing?

Details of projections less reassuring. So further easing can’t be ruled out.

Mr Draghi suffers first significant blow to his credibility (and authority?).

As expected, the ECB eased its monetary policy stance today but other than that financial markets were hugely surprised and significantly disappointed by what Mr Draghi announced. This is the first time traders have been completely wrong-footed by Mr Draghi. With markets positioned for the possibility of a larger than predicted package of measures, a surprise in the opposite direction magnified the immediate market reaction.

As a result, the immediate market response was more typical of what might be seen in the wake of a policy tightening rather than an easing. In the roughly two hour period between the initial rate announcement and the end of Mr Draghi’s press conference, the yield on German bonds (in both the 2 and 10 year area) jumped about 15 basis points while the exchange rate of the Euro climbed from $1.0540 to $ 1.0810, on course for its largest one day gain against the dollar in four years.

These pressures further intensified throughout the afternoon with the Euro climbing above $1.0930, German 10 year yields adding a further 10 basis points and Irish 10 year yields also ending the day about 25 basis points above their pre-ECB meeting levels.

A Very Limited ECB Easing In Spite Of Five Actions Today

For the eighth time since Mario Draghi became ECB president four years ago today saw a cut in one of the ECB’s main policy rates. In addition, the provisional end-date signalled for the expanded asset purchase programme (APP) that began in March was changed from September 2016 to March 2017 although this is not significant as the ECB has always emphasised that the programme would be open-ended in the sense that it will remain in place ‘until the Governing council sees a sustained adjustment in the path of inflation consistent with its aim of achieving inflation rates below, but close to 2%, over the medium term.’

Two other measures were announced that also seem intended to emphasise that ECB policy will remain relatively loose for a long, long time even if their near term impact is likely to be fairly limited. First of all, it was announced that refinancing operations will continue to be conducted at fixed interest rates until the end of 2017.

Secondly, it was indicated that the ECB will reinvest the principal payments on the maturity of assets purchased under the APP ‘for as long as necessary’.  Significantly, however, this phrasing is open to interpretations right across the spectrum, diminishing its immediate impact markedly. It does seem clear that these decisions are intended to lessen the risks of any abrupt pick-up in market rates towards the end of 2016 and through 2017.

Finally, the ECB decided to include debt instruments issued by regional and local authorities in the list of assets eligible for monetary policy operations. While important in ‘micro’ terms to broadening the reach of the APP, this is unlikely to have a marked ‘macro’ impact.

Draghi’s Reputation Doubles The Damage

Although some action on the part of the ECB was universally expected today, opinion was very much divided as to precisely what form it would take and how aggressive the measures would be. Media reports had suggested as many as twenty different options were being considered. Complicating matters even further was an acute sense in financial markets of Mr Draghi’s fairly consistent record of over-delivery relative to market predictions in terms of the scale and scope of easing measures.

Importantly, this meant that regardless of exactly what measures were expected, there was a strong sense that Mario Draghi would announce even more than anticipated. Judged from this perspective, today’s measures were particularly disappointing in that the deposit rate cut was probably at least 10 basis points less than markets had hoped for while a widely expected increase of some €10-20bn per month in the size of the asset purchase programme also failed to materialise.

New Projections Suggest Recovery 'Will Proceed'...

A partial explanation for today’s smaller than anticipated easing might be suggested by the ECB’s latest projections for activity. These are effectively unchanged from those made in September (barring a marginal upgrade to the 2015 GDP forecast from +1.5%to 1.6%). At the October ECB policy meeting and a range of subsequent comments Mr Draghi had focussed on downside risks to growth but these concerns have not been borne out by the new forecasts.

Indeed, today's press statement notably omits the previous wording that explicitly recognised that ‘risks to the euro area growth outlook remain on the downside’. While caution in this regard was still implicit in Mr Draghi’s tone today, there appears to be a greater confidence that recovery, even if it is gradual, will be sustained.

...But Lacklustre Growth And Low Inflation Likely To Persist

The details of the new ECB projections are not quite as reassuring in regard to growth prospects. While GDP growth rates for 2016 and 2017 are unchanged from September, the new forecasts envisage slower export and investment growth in each year but this is offset by a combination of slower import growth and stronger Government spending. Furthermore, consumer outlays have not been amended in spite of expectations of stronger jobs growth. These changes imply a less robust dynamic even if the projections of overall GDP growth are unchanged from those of three months ago.

Compared to those made in September, new ECB inflation projections have been revised down by 0.1% for both 2016 and 2017 to 1.0% and 1.6% respectively. Mr Draghi acknowledged that these projections ‘still indicate  continued downside risks to the inflation outlook and slightly weaker inflation dynamics than previously expected’ (our emphasis).

Today’s statement also highlights the role ‘sizeable economic slack weighing on domestic price pressures and headwinds from the external environment’ are playing in this regard. With today’s projections suggesting that Eurozone unemployment will remain above 10% in 2017 and downgrading foreign demand significantly for the full forecast period, persistently sluggish inflation might have provided the necessary argument for an aggressive easing today.

Draghi Now Chairman Rather Than Chief?

Our guess is that higher than expected inflation in October (even if this was reversed in the ‘flash’ estimate for November published earlier this week) created greater uncertainty about the current inflation dynamic. This may be hinted at by the unusual phrasing in today’s statement that ‘the Governing Council will closely monitor the evolution of inflation rates over the period ahead’ – the ECB’s medium term orientation means statements usually focus on the outlook rather than the current rate.

Disagreement within the Governing council on the current momentum in inflation may have strengthened the hand of a number of council members who are opposed to any further easing at this point. This could explain why the ECB seem to have backtracked from Draghi’s November commitment ‘to do what we must to raise inflation as quickly as possible’. Instead, we seem to have gotten an awkward compromise today entailing a package of measures calibrated in a manner that meant neither ‘doves’ nor ‘hawks’ got what they wanted.

On this interpretation, it is possible that expectations of further easing could begin to build again in 2016 if underlying inflation fails to pick up as expected. Indeed, a good case can be made for the merits of incremental rather than explosive policy changes at present.  It is probably a good deal safer to move in small steps when policy has now moved so far into previously uncharted territory and the economy is no longer in a crisis situation.

However, markets may be notably slower to anticipate further easing and a clearly chastened Mr Draghi was careful not to signal such a possibility. When asked if today’s cut in the deposit rate represented the lower bound, he replied curtly ’the cut we have decided today is adequate. Period.’.

Today’s ECB decision can only be partly rationalised by recent somewhat healthier trends in activity indicators and more erratic movements in inflation. More important is the significant communication failure between the ECB and the markets.  Mr Draghi’s almost god-like credibility with investors has clearly suffered. The ECB wouldn't have intended to cause today's rise in market rates and the exchange rate of the Euro. This holds out the prospect of greater volatility in markets in coming months and possibly more restrictive financial conditions for the Euro area in the early part of 2016.

With the ECB now effectively side-lined, the dominant influence on the exchange rate of the Euro and European market interest rates in the short term is likely to be the capacity of the Federal Reserve to begin raising US policy rates without significant fallout. Investors will be hopeful the Fed’s signalling capabilities are a little bit better than those of the ECB.




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