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Draghi attempts to underpin market confidence in ECB’s capacity and willingness to respond to increased downside risks to inflation and activity.
ECB to ‘review and possibly reconsider’ policy stance in March.
Key ECB rates expected ‘to remain at present or lower levels for an extended period’.
Further deposit rate cut likely and changes to asset purchases possible unless market conditions improve markedly or outlook for inflation changes sharply.
Markets still cautious following smaller than expected action in December and nervous about broader outlook. So, immediate market response not dramatic.
After surprising markets in December by doing less than expected, Mario Draghi resumed normal service today by suggesting that the ECB is likely to ease policy further at its next policy meeting on March 10th. Barring a dramatic improvement in financial markets or the prospect of much higher inflation in the next year or two, a further cut of 10 basis points in the deposit rate, possibly accompanied by some adjustment in the scale or duration of the asset purchase programme, looks very likely. Market expectations may centre on relatively modest action but further market woes or an even weaker inflation outlook might prompt more aggressive measures.
Between now and March expectations of additional ECB action will be a key influence on interest rate and currency markets. The contrast between the strong signal sent by Mr Draghi today and market perceptions of a divided and therefore sidelined ECB were immediately reflected in a softer Euro exchange rate and lower market interest rates. How much further these moves might go will depend both on the flow of economic and financial news and the comments of key ECB officials. These should indicate how forceful action is likely to be. With market opinion quite divided in this respect, this could prove to be an additional source of volatility in the weeks ahead.
After the disappointment of a much smaller than expected ECB easing in December and indications that Mr Draghi was facing stronger opposition to aggressive action from within the governing council, markets expected today’s ECB press conference to acknowledge the deterioration in market conditions of late as well as giving some indication of the implications of the recent drop in oil prices for inflation. While it was felt that this might keep open the prospect of further ECB easing, it was generally thought that this would be implied subtly rather than signalled forcefully. Against this backdrop, Mr Draghi’s comments today represent a clear verbal easing. However, having been disappointed in December, the initial response of markets was fairly measured.
That the ECB wants to signal a readiness to act is clear from today’s press statement that begins by indicating its key interest rates are expected ‘to remain at present or lower levels for an extended period of time’. In case that wording might not signal either its concern or intentions forcefully enough, these are set out very clearly in the paragraph that follows:
'Yet, as we start the new year, downside risks have increased again amid heightened uncertainty about emerging market economies’ growth prospects, volatility in financial and commodity markets, and geopolitical risks. In this environment, euro area inflation dynamics also continue to be weaker than expected. It will therefore be necessary to review and possibly reconsider our monetary policy stance at our next meeting in early March, when the new staff macroeconomic projections become available which will also cover the year 2018. In the meantime, work will be carried out to ensure that all the technical conditions are in place to make the full range of policy options available for implementation, if needed.’
We have included the paragraph above in full because it provides a comprehensive yet succinct overview of the issues now being debated around the ECB Governing council table. First of all, it sets out the various factors currently contributing to downside risks at present. Arguably, the key consideration here is the range of channels through which such risks could materialise. Indeed, the coincidence of wide ranging but possibly related concerns may well be interpreted as a signal of a deeper malaise.
The signalled need to review policy in March echoes the October promise to ‘re-examine’ policy that anticipated the December easing but the additional indication ‘ to possibly reconsider’ could be interpreted in two ways –either as a new and possibly stronger variant on the ‘monitor closely’ phrasing used in the past to signal the prospect of looming policy changes or as a qualifying clause that holds out the possibility that no policy change will be deemed necessary in March.
In view of the tone of other comments made today, we would clearly favour the former interpretation rather than the latter but this ‘optionality’ for March could be a concession to the hawks as Mr Draghi emphasised that the ‘Governing council was unanimous in being committed to this (today’s) line of communication’. His further indication that the council has the ‘cohesion’ to act further is also intended to dismiss any notion that divisions within the Governing council might prevent further easing.
The March meeting will likely entail significant downward revisions to the inflation projections made in September for 2016 and 2017. Indeed, the estimate for this year could be pared from December’s estimate of 1% to 0.5% or even lower as today’s statement indicated that inflation is ‘expected to remain at very low or negative levels in coming months’.
Mr Draghi pointed to three potential sources of downgrade to the inflation outlook. He referred to the weaker outlook for the global economy on foot of poorer prospects for emerging economies. He also said oil prices today are about 40% lower than those projections envisaged. Finally, he noted that the Exchange rate of the Euro is significantly higher than envisaged in December (we estimate about 4% higher).
It is not entirely surprising that Mr Draghi didn’t mention the strengthening of the Euro began when the market reacted to the ECB’s smaller than expected easing in December and started to consider the possibility of a more pronounced hawkish influence on ECB policy into the future. Indeed, even though Mr Draghi again stated that the exchange rate is not a policy target, an important element of today’s press conference may be a desire to protest the recent rise in the exchange rate of the Euro and to encourage expectations of a policy stance that might be expected to deliver a weaker currency in the months ahead.
It is important to note that the March ECB projections will include estimates for 2018 for the first time. This is significant because once-off developments like the recent drop in oil prices should have worked their way through the system by that point. Mr Draghi said today that the ECB will consider the ‘persistence’ and ‘materiality’ of oil effects as well as second round effects on other prices of other goods and services. As a result, the question these projections must answer is whether recent developments will have a lasting and large impact that makes it likely that even in 2018 inflation will still be clearly below the ECB’s target of below, but close to, 2%. To the extent that the projections envisage gradual progress towards to that goal, the case for major action in March will diminish.
A final important consideration in respect of the paragraph above that we have taken from today’s ECB press statement is the reference to work now being undertaken to ensure that ‘technical conditions’ are in place to ensure any policy measures implemented will not run into practical implementation problems. Mr Draghi said that the ECB wanted to be sure there are no technical limits to ‘the size of deployment ‘of any specific instrument. This work could encompass a wide range of deliberations ranging from considerations as to what might be the effective lower limit for the deposit rate to what measures might be need to ensure any step-up in asset purchase are permissible and do not to distort particular market segments.
At this juncture, market participants may feel additional ‘technical’ leeway is relatively limited. Hence, expectations of the scale of actions likely in March may not be dramatic. In this respect, it is likely that Mr Draghi repeatedly highlighted today the ‘power, willingness and determination of the Governing council to act’ because there are significant misgivings about the capacity of Central Banks worldwide to respond to any further down-leg in the global economy. The particularly dovish tone of today’s press conference is arguably both a reflection on the adverse market reaction to the ECB’s December measures and a more general sense of just how fragile market sentiment is at present. The confidence channel may be among the most important ways in which Central Banks need to influence economic agents and markets in the current environment.
To summarise, the tone Mr Draghi adopted today was altogether different from that of December. He effectively pre-announced a March policy easing- an outcome that was more dovish than generally envisaged. In one respect, this is simply the entirely appropriate response to a sharp deterioration in market conditions of late and the economic risks this implies.
Another consideration is the threat that any suggestion of complacency in today’s comments might have provoked a further unwanted firming in the exchange rate of the Euro and in market interest rates as well as the possibility that it could have been the catalyst for a further damaging deterioration in market conditions generally. We also think it is important to note that the more Mr Draghi achieves by verbal easing, the less may be needed in terms of policy measures in March.
For all of these reasons, the tone of Mr Draghi’s comments today makes eminent sense. However, markets can’t entirely disregard December’s unpleasant surprise or the sense that Mr Draghi’s capacity to deliver may be more limited than previously thought. This means they won’t be easily calmed by words alone. In what could remain fraught market conditions in coming weeks, the pressure on the ECB to deliver a further substantive easing may well intensify.
This non-exhaustive information is based on short-term forecasts for expected developments in the economy and financial markets. KBC Bank cannot guarantee that these forecasts will materialize and cannot be held liable in any way for direct or consequential loss arising from any use of this document or its content. The document is not intended as personalised investment advice and does not constitute a recommendation to buy, sell or hold investments described herein. Although information has been obtained from and is based upon sources KBC believes to be reliable, KBC does not guarantee the accuracy of this information, which may be incomplete or condensed. All opinions and estimates constitute a judgment as of the date of the report and are subject to change without notice.