The ECB has a relatively clear mandate

Mr Draghi Emphasises The Positive But Still Recognises Risks

• Inflation Seen Below 2% Through 2016; A Subtle Shift In Target?

• Mr Draghi Downplays Easing Prospects; Rates Lower For Longer Instead?

• Euro May Come Under Upward Pressure On Changed View Of ECB

• We See Lower inflation And Fragile Economy Prompting Renewed Easing Hopes


A sequence of slightly firmer than expected activity and inflation data through the past month meant that while opinion was divided, the general view was that the ECB would leave policy unchanged at today’s Governing council meeting. We felt that the emphasis ECB president, Mario Draghi placed last month on today’s new economic projections hinted strongly at the prospect of an easing. Consequently, we found the tone of Mr Draghi’s remarks today somewhat surprising, particularly as the new forecasts show inflation still running some distance below the ECB’s target through 2016.

The ECB has a relatively clear mandate. It is not clear that the current policy setting is entirely consistent with that mandate. For that reason, we don’t think a further easing can be discounted. Today’s press statement emphasises that inflation is expected to gradually move ’closer to 2%’ rather than to its mandated goal of ‘below but close to 2%’. Instead, the ECB contents itself that ‘inflation expectations…continue to be firmly anchored in line with our aim of maintaining inflation rates below but close to 2%. Today’s new projections suggest that 2016 will be the fourth year in a row in which Euro area inflation is 1.5% or lower. This implies a fairly liberal interpretation of what the word ‘close’ might mean.

Low Inflation Can Be Damaging

As we noted previously, inflation can be too low for comfort even in circumstances where outright deflation is avoided. Persistent very low inflation is usually a signal of unused (and thereby deteriorating) economic capacity. It also makes adjustments across countries or sectors harder because it implies a need to sustain cuts in nominal wages and prices. It makes debt sustainability more difficult as income growth is curtailed and, finally, it raises the ‘real’ cost of borrowing. These are all issues of relevance to the current situation in the Euro area and various soundings from ECB officials in recent months suggested a clear appreciation of the risks in this regard.

Two Possible Explanations Of ECB Inaction

We think two distinct but not mutually exclusive interpretations can be made in relation to today’s ECB decision and related comments that seem to hint at something of a change in thinking. The first is that the ECB has become more confident in the emerging recovery and now feels that its main task for the next year or two will be to nurture the upswing by preventing a premature firming in market interest rates (although it’s not clear how the ECB might respond to a stronger euro in FX markets).

On this view, the ECB’s focus is switching from consideration of further easing to considering how to prevent financial conditions from tightening too quickly. This would represent quite a shift from the message of the past few months. Our guess is that some council members may feel that the debate in Frankfurt should be closer to that underway for some time at the US Federal Reserve and the Bank of England more recently. However, we think the Euro area recovery still looks fragile and uneven. So we think the question of further easing may return before long.

A second and possibly complementary view of today’s proceedings is that in a still uncertain environment, the ECB is putting quite a lot of emphasis, possibly too much, on the monthly news-flow of economic information. Certainly, Mr Draghi, in explaining why no action was taken, focussed on a range of recent developments which he noted had ‘by and large been on the positive side’. In general, indicators through the past month have been somewhat better than expected but the examples he chose tend to illustrate the restrained nature of economic conditions and as such shouldn’t warrant any marked change in the thrust of policy.

For example, the final February PMI data rose modestly but remain very volatile as a drop in the preliminary reading hints. Mr Draghi also pointed out that consumer sentiment may have narrowed somewhat between Germany and elsewhere of late but across the Euro area consumer confidence weakened in February. It is also far from clear that his cited stabilisation in unemployment can be seen as an adequate outturn given the current level of joblessness. Similarly, the ECB president was far from convincing as he answered a question on whether credit data had shown any signs of the ‘good news’ he had anticipated a month ago.

Against this background, we don’t imagine that the ECB can have been hugely surprised or entirely comforted by the past month’s developments. Mr Draghi did note that the downside risks or ‘contingencies’ he had previously alluded to had not materialised and that the ECB’s baseline case had been confirmed. However, in a fluid situation, we think the risk of renewed pressure on the ECB to ease again could return rather quickly.  The catalyst could either be disappointing activity data or renewed downward pressure on inflation.

Mr Draghi noted today that there had not been any worsening in the outlook for inflation in the past month. This may owe something to the higher than expected preliminary inflation figure for February which remained unchanged at a still meagre 0.8% rather than declining as expected to 0.7% or possibly even 0.6%. Our best guess is that ECB Easing Hopes Fade But Could Return Before Long6 March 2014 4 inflation will ease at least temporarily in the next month or two and this is likely to cause pressure on the ECB to build again.

Inflation Projections Don’t Match ECB Target

Renewed pressure in the wake of a lower inflation rate in coming months would be likely because the new inflation projections published today show inflation remaining well below the ECB’s target for the foreseeable future. The projection for 2014 was revised down fractionally to 1% from 1.1%, the outlook for 2015 was left unchanged at 1.3% and the first public ECB estimate for 2016 came in at a notably lower than  envisaged 1.5%. The most recent survey of professional forecasters put the 2016 figure at 1.7%.  In what was an unprecedented and somewhat obvious attempt to rationalise today’s policy decision, Mr Draghi also indicated that inflation was seen around 1.7% in the final quarter of 2016. He indicated that the Q4 number suggested an element of upward ‘momentum’ in inflation. 

Today is the first time the ECB published two year ahead forecasts as early as the first quarter. As diagram 1 indicates, the ECB traditionally responded forcefully to projections showing above target inflation in the following year. So, the apparent tolerance of persistently low inflation points to something of an asymmetric policy reaction function. Given Mr Draghi’s particular reference last month to the significance of the new inflation forecasts and the fact that today’s forecasts for 2016 were lower than generally expected, this may seem surprising.

We think a number of arguments influenced this outcome. There is also a sense of material and possibly increasing differences of opinion on the appropriate policy response to current circumstances around the ECB governing council table at present. A sense of differences in thinking also comes from Mr Draghi’s adroit lack of an answer to a question on whether today’s decision had been unanimous.

One argument for no response to very low inflation could be that the ECB takes the view that it reflects positive rather than threatening developments. In this regard, it might be suggested that weaker inflation facilitates stronger increases in ‘real’ activity such as the 1.8% GDP growth rate the ECB envisages for 2016 and a necessary rebalancing of costs and, consequently, activity across countries. As noted above, we think such prospects are likely to be outweighed significantly by a range of risks surrounding low inflation.  Mr Draghi’s outline today of the role played by lower energy prices in explaining recent declines in inflation in the Euro area suggested this ‘healthy’ disinflation view has some supporters in Frankfurt even if it ECB Easing Hopes Fade But Could Return Before Long6 March 2014 5 was  at odds with his detailed justification of the ECB’s action in the face of similarly low inflation as recently as last November.

A Shift In Policy Guidance, But Could It Work?

A second and potentially important rationale for ECB inaction is that the scope for further broadly conventional policy response is very limited at present and consequently, in the absence of further downside shocks, the best response is to commit to leave interest rates ‘ lower for longer’. This is consistent with the two handed nature of Mr Draghi’s comments today. In marked contrast to the press conferences of recent months, he refrained from emphasising the ECB’s determination to do more if needed (although this commitment remains in the press statement). Instead, he seemed to offer a slightly different form of forward guidance.

Again, it should be noted that the opening press statement continues to indicate that policy will remain accommodative for ‘as long as necessary’. However, his remarks today that an accommodative policy ‘will stay in place after improvements in the economy’ might suggest a willingness to contemplate a slower response to recovery than might have been expected in the past. Mr Draghi suggested that this approach would prompt an easing in ‘real’ borrowing costs as recovery took hold. However, this may be far from optimal depending on what precisely he means by this, it might suggest that for the next few years ECB policy would have a pro-cyclical tendency, becoming easier as the economy has less need of support while doing less when it is more badly needed now.

Mr Draghi suggested this approach could be justified by the degree of slack there is in the economy at present. While there is no universally agreed measure of this ‘output gap’ for the Euro area economy, there is a broad consensus that it is substantial. Unfortunately, there is also a longstanding view recently highlighted by a Federal Reserve research paper (“Aggregate Supply in the United States: Recent Developments and Implications for the Conduct of Monetary Policy” by Reifschneider, Wascher and Wilcox) that not attempting to reduce this more quickly by additional policy action risks damaging the economy’s long term potential.

The Euro May Become A Problem

A number of questions at today’s press conference dealt with the exchange rate of the Euro. Mr Draghi’s answers didn’t stray too far from those he has given repeatedly in the past but his relaxed tone coupled with the reduced emphasis on further easing gave ECB Easing Hopes Fade But Could Return Before Long6 March 2014 6 the single currency significant upward impetus today. Mr Draghi’s indication that a 10% rise in the exchange rate would reduce inflation by 0.4/0.5 % is in line with most estimates of the likely impact although perhaps towards the lower end of a plausible range in a generally disinflationary environment. Our sense is that upward pressure on the Euro by adding to downward pressures on inflation could be an additional argument for ECB action before long.

Liqudity Action Also Less Likely In Near Term

While most of the focus of today’s press conference was on the interaction between the broad economic environment and the policy stance of the ECB, Mr Draghi also reminded us again that liquidity instruments would be deployed in response to money market problems rather than broader economic issues. Again, this tends to highlight the difficulty in taking ‘measured’ action against a modest deterioration in the inflation outlook.

Significantly, the ECB’S concerns in regard to liquidity also seem to have diminished of late. In this regard, Mr Draghi seemed to downplay, at least at the margin, the prospect of an end to the ECB’s policy of sterilising the product of its Securities Market Programme. Such a possibility has received a great deal of attention of late because of the somewhat surprising public support given by the Bundesbank to this proposal. In downplaying the likelihood of such action, Mr Draghi made the rather surprising remark that its effectiveness was somewhat reduced by the dwindling maturities of the relevant bonds as this would limit the timeframe for which sterilisation could be used. In February 2013, the ECB indicated that the average maturity of these bonds was 4.3 years at that time which would suggest this mechanism could be useful for some time to come.

Where Next?

We had anticipated that the ECB would ease policy today. When it failed to do so, we expected that the new projections would show a clearly firmer inflation and growth trajectory that would demonstrate the rationale for unchanged policy. Instead, we got forecasts of surprisingly low inflation through 2016 and a small but important shift in the broader outlook that no longer envisages inflation hitting the target of ‘below but close to 2%’. We also got a possibly new form of guidance that envisages ‘real’ borrowing costs easing as inflation picks up implying some possibility of pro-cyclical ECB policy.

For these various reasons, we still have some difficulty rationalising today’s ECB decision. Because we think the economy remains fragile, ECB Easing Hopes Fade But Could Return Before Long6 March 2014 7 inflation could slip lower in the next month or two and the exchange rate of the Euro may become uncomfortably strong, we think the next few months could be marked by significantly increased volatility and renewed pressures for further ECB action.