The European Central Bank left its key interest rates unchanged today

 Concerns about prolonged low inflation driving consensus to act again.

• Rising Euro exchange rate also regarded as a ‘cause for serious concern’.

• Draghi indicates ECB ’now comfortable with acting next time’.

• Governing Council to see if new projections alter inflation outlook—we think projections need to be revised down unless action is taken.

• Scale and nature of ECB easing depend on forecasts and exchange rate movements.

• At this point 10-15 bp cut in key policy rates and liquidity measures seem likely.

• Some limited form of asset purchases also possible but ECB will be slow to embrace aggressive QE.

As was generally expected, the European Central Bank left its key interest rates unchanged today. Markets also expected some indication from Mr. Draghi as to what circumstances might trigger a further easing. In the event, Mr Draghi went much further and suggested a decision in principle had been taken to ease policy in June.

His comments also implied the Governing Council would decide upon the shape and scale of that action in the light of the staff projections for inflation (and activity) that will be prepared for the June 5th policy meeting of the Governing Council.

Mr Draghi Pre-Commits

It was generally expected that Mr Draghi would strike a dovish tone today. The real surprise today was the clarity of the signal he sent in relation to the ECB’s intentions. It would take evidence of dramatically changed economic conditions centred on a notably stronger rebound in inflation to allow the ECB to credibly leave policy unchanged in a month’s time. At this point, the chances of such a turnaround appear remote. As a result, market focus will now turn to the question of what precisely will be done.

In the course of what was generally a low key press conference, Mr Draghi indicated that the ECB would be ‘comfortable with acting next time’. He said there was ‘a consensus about being dissatisfied with the projected path of inflation’ as well as ‘a consensus not to accept it as an act of nature’. While he reiterated that the bulk of the recent drop in inflation was due to lower food and energy prices, he said the ECB had to consider whether other factors such as a strong exchange rate and weak demand might keep inflation low in the future.

Subtle But Significant Changes In ECB Thinking

The tone of these remarks implies ECB thinking appears to have evolved significantly of late to encompass a view (first highlighted last month) that persistently low inflation represents a threat to its mandate as well as to the general economic outlook. This month’s statement no longer refers to the support low inflation offers to ‘real’ incomes in the Euro area. As we noted a month ago, persistently low inflation is likely to reflect constraints on spending power.

Compared to last month, there are quite a number of small but important changes to the opening press statement that point towards changed thinking in Frankfurt. For example, the addition of the word ‘only’ in the phrase ‘…our expectation of a prolonged period of low inflation followed by only a gradual upward movement in HICP inflation rates’ hints at a subtle but significant change in terms of ECB attitudes to Draghi Signals ECB Likely To Ease In June8 May 2014 3 the expected evolution of inflation in the next year or two.

Consistent with this view, today’s press statement is tonally a good deal more cautious on the emerging economic recovery, particularly in the light of what have been reasonably encouraging activity indicators in the past month. April’s reference to a recovery ‘increasingly supported by firmer domestic demand’ gives way to a comment simply noting that the recovery ‘continued at the beginning of the second quarter’. Similarly, last month’s suggestion that ‘some further improvement in domestic demand should materialise’ is replaced by the less promising judgement that ‘domestic demand should continue to be supported by a range of factors’.

Lest there be any doubt that ECB thinking is changing, the longstanding expectation that ‘economic activity is also expected to benefit from increased demand for Euro area exports’ disappeared completely from this month’s statement. This omission could reflect crystallising concerns about slower demand from emerging markets as well as the adverse impact of a strong Euro exchange rate on exports from the single currency area.

Might The ECB Change Its Mind? 

If there are strong signals of the ECB’S clear inclination to act, we should briefly consider what circumstances might prevent such action. Obviously, a very sharp rise in inflation in May would imply that the concerns signalled today by Mr Draghi about excessively low inflation are overdone. While monthly readings can be volatile, the likelihood is that inflation will stabilise or edge lower in the next month or two. So this shouldn’t be an obstacle to an easing in June. 

Similarly, it seems probable that the next set of ECB projections will show a marginal downward revision from those made in March. Our current expectations are for inflation rates of 0.8%, 1.2% and 1.5% for the years 2014, 2015 and 2016 respectively but they incorporate an assumption of further ECB easing. These compare to March ECB projections envisaging inflation of 1.0%, 1.3% and 1.5%. With Mr Draghi’s comments today hinting at a cautious view on growth, it might not be unreasonable to expect that, in the event of unchanged policy, there could be modest downward revisions to ECB inflation projections for all three years, This, in turn, would justify a June easing.

A Small Cut Or The Big Bazooka?

If Mr Draghi’s words today and prospective inflation developments both point towards a June policy easing, the key question is exactly what might be done. In an important speech in late April, Mr Draghi suggested the precise policy response would depend on the nature of Draghi Signals ECB Likely To Ease In June8 May 2014 4 the ‘contingency’ facing the ECB. He suggested that various forms of an ‘an unwarranted tightening of policy’ would be met by appropriate combinations of interest rate cuts and liquidity enhancing measures.

A key aspect of Mr Draghi’s late April speech was the consideration of what policy response might be appropriate in the event of ‘a worsening of the medium term outlook for inflation’ which he suggested might occur if a demand shock were to ‘derail’  the recovery or a supply shock were to ‘loosen the anchoring of inflation expectations’. He said this would require an aggressive response and that ‘the limited margin for manoeuvre that remains over short term interest rates would not be sufficient’.

So, the critical issue is whether the concerns highlighted today by Mr Draghi are closer in nature to problems that can be tackled by actions on interest rates and/or liquidity measures or whether they require more radical intervention. In principle, they might seem to be closer to the latter than the former in the sense that the issue is prolonged and uncomfortably low inflation rather than an unwarranted tightening of policy.

However, a significant focus on the role of the exchange rate of the Euro and today’s reference to ‘tight levels of credit standards’ even if credit conditions appear to have stabilised would seem to allow a theologian or an ECB policymaker latitude to argue that a rate cut and liquidity measures might be justified and adequate. An advocate might also suggest that the need to guard against a modest undershooting of the inflation target would not constitute the sort of ‘shock’ that would justify embarking on unprecedented and controversial Quantitative Easing in the shape of an asset purchase scheme. Finally, the fact that the ECB still sees inflation expectations anchored close to 2% would also argue that aggressive action is not required at present.

We Think The ECB Is Unlikely To Go For Shock And Awe…At Least For Now

Our judgement could change materially as ECB policymakers clarify their intentions in the next couple of weeks but, for the moment, we think a June easing will centre on a10-15bp cut in the ECB’s key policy rates implying the deposit rate would drop into marginally negative territory (from zero at present). Our best guess is that this would be augmented by some combination of liquidity measures such as an extension of fixed allotment LTRO’s and a temporary suspension of actions to sterilise the ECB’s Securities Market Programme.

We think that the ECB is unlikely to be ready to immediately operationalise a large scale Asset purchase programme although Draghi Signals ECB Likely To Ease In June8 May 2014 5 a formal commitment to buy asset backed securities could be given. Notwithstanding the repeated commitment to use ‘unconventional measures within its mandate in order to cope effectively with risks of a too prolonged period of low inflation’, we don’t think that there is likely to be a consensus on the Governing Council that the current outlook constitutes a shock on the scale that would justify purchases of Government bonds.

This analysis suggests that in spite of an unusually strong statement by Mr Draghi today there is still considerable uncertainty as to exactly what and how much action will be taken. Our sense is that Mr Draghi might again have seemed to overpromise but the market is still largely of the view that, if required, he will be able and willing to deliver. Differences of opinion as to exactly what could and should be delivered might inject some measure of volatility into FX and bond markets in coming weeks.