The ECB has a clear bias towards further easing

 Mr Draghi clearly more dovish.

• Weaker economy or limited impact from recent easing initiatives to trigger more action.

• Tone of comments increase prospect of further action markedly.

• Draghi emphasises ‘unanimous‘ view of ECB to allay concerns about increasing differences.

• Minor teaks possible next month but early 2015 focal point for substantive action.

• Nature of further action to be examined by ECB and national central banks, implying sort and scale of measures are not yet agreed.

Today’s ECB press conference was a good deal livelier than expected and suggests that the ECB has a clear bias towards further easing. Indeed, some small tweaks to existing programmes could be announced as early as next month. However, the early months of next year appear a more likely focal point for the prospect of substantive ECB action

According to ECB president Mario Draghi, more substantive action would be triggered by either of two ‘contingencies’; the failure of current policy initiatives to produce a marked increase in the ECB’s balance sheet or a further deterioration in Euro area economic conditions that implies a weaker outlook for inflation.

Our sense is that by early 2015 it should be possible to make some judgement on the likelihood that either of these contingencies will materialise. In turn, this implies markets will be focussed on the prospect of significant ECB policy action by the end of the first quarter if not sooner. In the interim, today’s strong signal from Mr Draghi should encourage traders to explore the downside for Euro area term rates and the exchange rate of the Euro.

The ECB Is Sensitive To Various Risks

Today’s message from Mr Draghi suggests the ECB is very sensitive to the disappointing tone of recent Euro area activity and inflation indicators. It also hints that the ECB is sensitive to market concerns that the ECB might be a little complacent in this regard - a month ago we commented on the very negative market reaction to what we thought were subtle signals from Mr Draghi of both an awareness of downside risks and a willingness to respond. Today’s message was altogether more forceful and emphasised a willingness to act forcefully and quickly.

Today’s opening ECB press statement showed a significant sensitivity to media reports that the ECB governing council was split and some members were less than happy with some of Mr Draghi’s recent pronouncements. Judged from this perspective, Mr Draghi won a major battle in two respects today; first of all by having a commitment to significantly raise the size of the ECB’s balance sheet inserted in today’s opening press statement and second, in also signalling in today’s statement that an examination of further unconventional policy options has been initiated.

Significant changes to the tone of today’s ECB statement represent a strong endorsement of Mr Draghi’s leadership and appear to back the ECB into something of a corner in terms of further action. That said, we are not entirely convinced that all governing council members share a common view of what legitimately can and should be done if conditions deteriorate further and/or the ECB’s balance sheet fails to expand materially.

Today’s strong declaration of the ECB’S willingness to ease further is signalled by the insertion of a phrase in the opening press statement indicating ‘looking ahead, and taking into account new information, the Governing Council will closely monitor and continuously assess the appropriateness of its monetary stance.

One Concern Is The Risk Of A Further Economic Deterioration

While Mr Draghi highlighted the risk of a further weakening of economic conditions as one of two ‘contingencies’ that would warrant further easing, there is little sense that there has been a dramatic downgrading of the economic outlook of late by the ECB. Today’s press statement acknowledges ‘..recent forecasts by private and public institutions, which indicate a downward revision of real GDP growth up to 2016, with the outlook for a modest recovery remaining in place’. Importantly, it goes on to say that ‘This picture is broadly in line with the Governing Council’s current assessment’.

So, there is little in these remarks on the current economic outlook to suggest any great likelihood of dramatic policy action next month even though new ECB projections will probably entail yet another round of downward revisions to numerical forecasts for both growth and inflation out to 2016. Our sense is that the ECB would need to see greater downside risks crystallise before it takes another step into unknown territory for policy. However, the inference that the recent loss of momentum in activity is regarded as something that may persist for the next two years rather than a temporary blip clearly strengthens the case for further easing.

Another Concern Is That Recent Initiatives May Not Do Enough

The other ‘contingency’ highlighted by Mr Draghi today relates to the possibility that the combined effects of the measures recently announced by the ECB (entailing Targeted Long Term Refinancing Operations and Covered Bonds and Asset Purchase programmes) fail to ‘have a sizeable impact on our balance sheet, which is expected to move towards the dimensions it had at the beginning of 2012’.

The inclusion of this comment came as a major surprise. As we ECB Emphasises Willingness To Ease Further6 November 2014 4 noted last month Mr Draghi seemed to downplay the significance of a numerical target at the October press conference and, in the interim, media reports suggested that a number of Governing Council members were opposed to providing specific guidance of this type.

Mr Draghi further elaborated today that he had in mind the level of the balance sheet prevailing at end March 2012. At that point, the ECB balance sheet reached €2.96bio while it currently stands at €2.05bio, implying ECB expectations that it should rise by somewhere between €700-900mio.

Our sense is that this represents a very ambitious target given the disappointing uptake of the first TLTRO and the limited size of market segments being targeted in current asset purchase programmes.  As commercial banks continue to repay previous liquidity support, the net increase in the ECB’s balance sheet could fall some significant distance short of the implied target. In such circumstances, expectations of further asset purchase programmes embracing Government bonds are likely to build. The outcome of the December TLTRO could be an important pointer in this regard.

Scope Of Further Easing Yet To Be Agreed

If there were significant questions about the ECB’s willingness to ease further before Mr Draghi’s commitments today, there were even greater doubts about the capacity of the Governing Council to agree what further measures  might be consistent with the ECB’s mandate and effective in the Euro area’s current circumstances.

The indication today that ‘The Governing Council has tasked ECB staff and the relevant Eurosystem committees with ensuring the timely preparation of further measures to be implemented if needed’ says some important things about the ECB’s readiness for further action. First of all, the ECB hasn’t an agreed arsenal of further ‘unconventional’ measures at its disposal at present. Second, work in this regard is to involve representatives of the national Central Banks as well as Frankfurt staff to ensure a broad buy-in in relation to whatever measures are chosen. This also implies the likelihood of important differences of opinion as to where the boundaries of what is possible may lie.

Market Likely To Follow Mr Draghi’s Guidance

While we thought the market underestimated Mr Draghi’s comments of a month ago, we were surprised by how forceful Mr Draghi was today. The immediate market implications are fairly clear as expectations ECB Emphasises Willingness To Ease Further6 November 2014 5 of substantive further ECB action will encourage traders to test the downside for Euro area term interest rates relative to rates elsewhere and also sustain pressure on the exchange rate of the Euro.

Our sense is that Mr Draghi and some of his more dovish colleagues are pushing some of their colleagues a good deal further than they might like to go. Mr Draghi’s repeated references to the unanimous nature of today’s press statement implies a strong prospect of further ECB easing measures  by early next year but remains some way short of a clear commitment. We think the path to additional action may have many twists and turns.

P.S. In Ireland today much of the focus on the ECB meeting centred on the release of previously confidential correspondence between the ECB and the Irish Government in the immediate run-up to Ireland’s entry into the EU/IMF assistance programme at the end of 2010.

The most notable letter from ECB president Jean Claude Trichet to Irish Finance Minister Brian Lenihan dated November 19th doesn’t contain any shock disclosures. However, it echoes the tone of similar letters the following year to the governments of Spain and Italy that show at very least a significant incursion into the realms of domestic economic policy and a very specific prescriptive approach that is difficult to reconcile with a longstanding emphasis on the separation of monetary and fiscal policy

It is far from clear how the ECB would have dealt with the adverse implications for the integrity of the Euro area had it stopped authorising the provision of Emergency Liquidity Assistance to Irish financial institutions. The ECB’s powers in relation to ELA principally stem from the impact of such measures on the objectives and tasks of the Eurosystem. Threatening to take measures that would likely have had substantial adverse consequences for the Euro area as a whole at a time of broadly-based financial fragility and uncertainty would appear to be an unusual and extreme course of action for the ECB or any major central bank to take.