Moving to healthier activity and inflation will take quite a while

ECB leaves policy unchanged and suggests an intention not to move for ‘an extended period’.

• Slightly more focus on slower growth and increased risks of late.

• But ECB encouraged by reaction to June measures and hopes for large impact from TLTROs.

• Only a major shock would prompt near term move but disappointing growth and very low inflation as well as Ukrainerelated risks will sustain the possibility of quantitative easing.

As expected, today’s meeting of the ECB’s governing council left policy unchanged and the subsequent press conference by ECB President Mario Draghi suggested little inclination to alter policy in either direction for some significant time barring a dramatic deterioration in economic conditions.

The broad message today was that the Euro Area economy is developing along the lines the ECB envisaged when it  announced a range of easing measures back in June and it envisages that those actions will help push activity and inflation onto trajectories that are notably stronger than have been evident of late.

There is also a strong signal that the process of moving to healthier activity and inflation will take quite a while, thereby underpinning the ECB’s intention to keep policy rates unchanged ‘for an extended period of time’. In this way, the ECB is clearly differentiating its policy outlook from that of the US Federal Reserve or the Bank of England and thereby seeking to influence the value of the Euro on FX markets.

Downside Risks Remain

However, Mr Draghi also hinted that the ECB is at least a little concerned about emerging economic developments. The most notable feature of what was a fairly low key press conference was an acknowledgement of the continuing vulnerabilities in a still tentative upturn. Mr Draghi noted that he had previously characterised the recovery as ’weak, fragile and uneven’ and offered a somewhat downbeat update in respect of each of these aspects.

Possibly, Mr Draghi’s most significant comment today was to note there has been ‘some slowing down in growth momentum’ of late. While he suggested that ‘volatile’ readings in some indicators of late partly reflected technical factors such as a reduced number of working days in the second quarter, he didn’t offer this as a full explanation of the range of disappointing data of late. These vary from negative Italian GDP, through poorer German orders, production and business sentiment to a notable slowdown in area wide household income growth.

Geo-Political Concerns Attracting More Attention

In discussing the fragile nature of the recovery, Mr Draghi spent some time discussing the potential damage from ‘heightened’ ECB Watching, Waiting And Still A Little Bit Worried 7 August 2014 3 geopolitical risk, particularly that posed by developments in the Ukraine. He noted that analysis based simply on relatively modest trade and financial links might understate the true effects once ‘sanctions and counter-sanctions’ are undertaken.

By extension, this suggests that the ECB has undertaken a fair amount of scenario analysis on the possible consequences of an escalation of problems in the Ukraine and now has contingency plans in place which, in extreme circumstances, might entail a further significant easing through ‘unconventional’ policy measures.

Mr Draghi also emphasised the ‘uneven’ nature of the upswing and argued that this owed quite a lot to substantial differences in structural reform efforts between countries. In so doing, he attempted to shift responsibility for at least some of the shortcomings in growth back on to national governments. Of course, this judgement would also weaken the case for additional action by the ECB at this point.

Plenty Of Reasons To Stay On The Sidelines

Although he acknowledged risks in the current environment, Mr Draghi advanced a number of arguments why we should not expect further ECB action anytime soon. First of all, he indicated that in spite of a measure of discomfort about recent developments, the evolving picture is still broadly in line with the ECB’s baseline scenario in which economic growth and inflation gradually pick up to more acceptable rates.

In addition, Mr Draghi stated that the ECB was generally pleased with the immediate impact of the measures it had announced in June. In the interim, the exchange rate of the Euro has softened by a little over 1% as, according to Mr Draghi, markets recognise that ‘monetary policies in the Euro area and the US and UK will stay on a divergent path for a long time’.

Mr Draghi added that interest rates had eased and excess liquidity had increased and stabilised in Euro area money markets. So, the June measures are already working in the right direction even if the capacity of these developments to alter the trajectory of the ‘real’ economy appears quite limited.

It would seem that the ECB has altogether greater expectations for Targeted Long Term Refinancing Operations (TLTROs) to support an ECB Watching, Waiting And Still A Little Bit Worried 7 August 2014 4 improvement in bank lending and economic activity. With the first tranche of TLTROs to be allocated in mid-September and subsequent TLTROs each quarter to mid-2016, these actions will take some time to feed into increased lending and stronger economic activity. However, they hold out the promise of a sustained monetary stimulus if they attract the scale of uptake which the ECB seems to expect.

Mr Draghi seemed somewhat less confident of the likely impact that its plans to activate the Asset Backed Securities (ABS) market might have. Again, albeit to a much lesser extent, this work-in-progress lessens the pressure to consider further initiatives in the absence of a major negative shock to the Euro area economy.  On a completely different level, the calm manner in which markets responded to recent problems in Banco Espirito Santo also appears to suggest notably less worrisome circumstances at present to those prevailing through most of the recent crisis.

On Hold Except For Emergencies

Our reading of today’s press conference is that the ECB remains concerned about the evolving economic picture although it remains hopeful that a gradual if uneven improvement will take hold. It seems quite confident that the upcoming TLTROs will make a significant contribution to a healthier trajectory in activity and inflation. Our sense is that it would take a sharp deterioration in economic circumstances to prompt additional easing before the full impact of the TLTROs can be assessed-a timeframe that likely stretches well into the first half of 2015.

While Mr Draghi hinted today that the ECB has one eye firmly on events in the Ukraine as a possible trigger for an adverse shock, we see this  as signalling that the ECB is anything but complacent  rather than hinting that any  additional policy action might be contemplated in the months ahead.