While no policy change was expected, today’s ECB policy meeting was widely anticipated. for a couple of reasons.

• Mr Draghi highlights concerns but stops short of committing to easing

• Notably weaker growth outlook and lower inflation argue for further policy action

• Mr Draghi emphasises need to fully assess impact of lower oil prices

• Our sense is that deeper ECB divisions are still delaying sovereign bond buying

• Pressure likely to build for substantive action in early 2015

• Prospect of ECB easing to weigh on Euro and interest rates

While no policy change was expected, today’s ECB policy meeting was widely anticipated for a couple of reasons. First of all, the ECB released its new economic projections that reveal yet another downgrading of the outlook for growth and inflation both for 2015 and 2016. More importantly, markets expected some clear indication of how and when the ECB would respond to a worsening economic environment. 

Markets Disappointed By Absence Of Clear Easing Signal.

Although Mr Draghi hinted at action early next year when ’the Governing council will reassess the monetary stimulus achieved, the expansion of the balance sheet and the outlook for price developments’, his comments disappointed markets that wanted a clear plan today rather than a vague promise. Mr Draghi’s argument that the ECB needed more time to assess the full impact of recent falls in oil prices attracted little sympathy. As a result, the Euro rose modestly on FX markets as Euro area term interest rates in the immediate aftermath of the monthly ECB press conference.

Our sense is that pressure for further ECB easing is likely to build through the early part of 2015 and this will dominate the relevant interest rate and currency markets. We don’t know that Mr Draghi will be able to build a consensus sufficient to allow meaningful action as soon as the next Governing council policy meeting scheduled for January 22nd next but it may be very hard to stay on the side-lines until the next set of economic projections are released on March 3rd.

Mr Draghi’s remarks today were clearly intended to emphasise the ECB’s determination to bring inflation back in line with its mandate of ‘below but close to 2%’ but the market chose instead to focus on doubts about his capacity to deliver. Today saw downwardly revised forecasts, an acknowledgement that risks to the outlook remain tilted to the downside and Mr Draghi repeatedly expressing the need to ‘avoid spillovers to inflation expectations and wage formation from the sharp fall in oil prices’. Unfortunately, markets were unsettled by what seems to be a large gap between this commitment and the absence of concrete action.

Forecasts Suggest More Policy Stimulus Needed.

While uncertainties around economic forecasts need to be emphasised, the picture they paint can be revealing. In this regard, the ECB’S new projections for activity clearly highlight the frailties of the Euro area economy. The manner in which projections are presented can also ECB Disappoints But Probably Only Delays Further Easing4 December 2014 3 be important in terms of their implications for policy and the new ECB inflation forecasts are particularly notable in this context.

The revision to the GDP growth rate forecast for 2015 from 1.6% in September to just 1% today implies an altogether weaker trajectory for activity now than the ECB envisaged just three months ago. Indeed, with the 2014 growth estimate unchanged at 0.8%, this implies relatively little forward momentum through the next twelve month. A downward revision to the 2016 GDP forecast from 1.9% to 1.5% hints that subsequent progress is likely to remain fairly slow. Ominously, downward revisions to consumer spending and employment for 2016 are larger than those for 2015.

The ECB also revised down its inflation projections significantly, particularly in relation to 2015 to just 0.7% compared to 1.1% three months ago. Significantly, the projection for 2016 has also been revised down albeit marginally from 1.4% to 1.3%. In addition, ECB vicepresident, Vitor Constancio, indicated today that even at end 2016, inflation is expected to be just 1.4%.

Mr Draghi further emphasised that the projection cut-off date of mid-November meant that recent sharp falls in oil prices were not incorporated into today’s forecasts for inflation, implicitly highlighting the prospect of significantly lower outturns. This suggests the ECB sees a prolonged period of very low inflation and relatively little upward momentum at the end of the forecast period. This raises a significant question as to whether the ECB’s current policy settings are making sufficient progress towards achieving its mandate.

Mr Draghi Pours Oil On Troubled Waters.

In these circumstances, two explanations suggest themselves for the absence of a policy response. First of all, it might be argued that a policy reaction isn’t warranted because the current inflation outlook (into the policy relevant medium term) is unduly influenced by oil price movements. The alternative is that the ECB is paralysed by deep divisions as to what the ECB can do within its mandate to respond. The reality is that both arguments are probably relevant to the current policy debate on the ECB Governing council.

Mr Draghi did his very best today to emphasise the need to consider fully the implications of the recent sharp decline in oil prices in arriving at an appropriate policy response. There are certainly good grounds for such reflection. Two of the ECB’s more notable policy mistakes- interest rate increases in July 2008 and again in April/July 2011 occurred against a backdrop of large oil price increases.

In this context, some of Mr Draghi’s remarks today where he warned of the need to avoid the impact of lower oil prices becoming ‘embedded’ in ‘inflation expectations and wage formation’ seem toecho Mr Trichet’s April 2008 comments that ’Second-round effects stemming from the impact of higher energy and food prices on wage and price-setting behaviour must be avoided’. However, in both 2008 and 2011 the ECB took what we might describe kindly as controversial action against the risk rather than the reality that inflation expectations might become unanchored. A consistent and symmetric approach would probably have seen an easing today.

Assessing the overall impact of sharp movements in oil prices is complicated by the many channels through which it affects activity and inflation. It clearly reduces headline inflation and can feed into wage formation and inflation expectations. As Mr Draghi noted today, it can also prompt a rise in ‘real’ interest rates. However, it also boosts spending power and in the words of Bundesbank President, Jens Weidmann, last week, might ‘act as a mini-stimulus programme’.  Against this, it can be regarded as boosting the economy’s supply potential and in certain circumstances could therefore increase the shortfall between actual and potential output. So, differences in the timing of demand and supply side consequences can also be important.

Which of these many effects will dominate tends to be specific to the particular circumstances of an economy at a point in time. So, it is not unreasonable that opinions might differ around the Governing council as to what policy response might be appropriate at present. Our sense, however, is that Mr Draghi’s focus on this aspect today owes more than a little to efforts to divert attention away from deeper divisions around the policy-setting table.

Bond Buying Still Divides Governing Council.

It is fairly clear that there continue to be notable differences among ECB policymakers as to what could and should be done to restore inflation closer to 2%. Some sense of the fractious nature of such discussions was hinted at by Mr Draghi’s terse response today to a question as to the ECB’s capacity to purchase sovereign bonds when he assured the questioner that this would be within the ECB’s mandate and added that ’not to pursue our mandate would be illegal’.

An even more striking pointer to the sort and scale of difficulties the ECB may be facing came when Mr Draghi indicated that the decision to slightly strengthen the wording of the opening statement’s reference to an increase in the ECB’s balance sheet as ‘intended’ rather than ‘expected’ was not arrived at with the unanimous support of the Frankfurt based ECB Disappoints But Probably Only Delays Further Easing4 December 2014 5 directorate.  

Taken together with the rather trenchant speech against Quantitative Easing made last weekend by directorate member, Sabine Lautenschlager, it seems clear that significant obstacles to an early introduction of a programme of ECB sovereign bond buying have yet to be overcome. Importantly, owever, Mr Draghi also indicated that there was no requirement for unanimity to implement additional easing.

Pressure For Early Easing Likely To Intensify.

In normal times, downward revisions to economic projections such as we saw from the ECB today would have been sufficient to prompt an immediate policy easing. These are not normal times. Our sense is that current difficulties in formulating a policy response relate much more to fundamental differences regarding the adoption of a programme of sovereign bond buying than to any debate about the longer term consequences of tumbling oil prices.

Our sense is that pressure for further ECB action will build through the first quarter in the shape of downward pressure on inflation and disappointing news on activity. Indeed, it would not take a great deal for early January data to tilt the balance in this regard. As today’s market moves show, uncertainty about policy is likely to make for choppy trading conditions. However, notwithstanding the lack of clarity from today’s ECB meeting, the sense that the question is when rather than whether the ECB will introduce a sovereign bond buying programme is likely to dominate market sentiment towards Euro area interest rates and the exchange rate of the single currency.