The ECB left its key policy interest rates unchanged today

Significant ‘verbal easing’ today through hints at possible further action.

• Draghi emphasises risks from a ‘too prolonged period of low inflation’.

• ‘Rich and ample’ discussion on possible need for policy easing and what might be done.

• ECB not out of room on rate cuts but Draghi highlights ‘unconventional instruments’

• ECB now ‘unanimous’ on commitment to use QE if needed.

• However, Draghi won’t be drawn on specifics. So action unlikely to be imminent.

• Exchange rate also ‘increasingly important’. ECB likely concerned currency could move too high.

• Generally dovish ECB tone partly a correction to last month’s press conference.

• Expected inflation rebound in April and likely strong Q1 GDP are near-term obstacles to early easing. We see easing possible around mid-year.

As expected, the ECB left its key policy interest rates unchanged today. However in the regular press briefing that followed, ECB president Mario Draghi struck a tone that was subtly but clearly different to that of a month ago. He noted a ‘rich and ample’ discussion took place on whether further easing was required and what form such action might take.

In an important sense, today’s remarks were clearly intended as a form of ‘verbal easing’ but they also likely reflect a significant view within the Governing council that in spite of some positive signs in relation to economic activity, downside risks remain substantial and may need to be countered.

Today’s press statement makes it clear where the ECB’s priorities lie at present by noting ‘We are resolute in our determination to maintain a high degree of monetary accommodation and to act swiftly if required. Hence, we do not exclude further monetary easing…’ In one respect, this phrasing is just the latest in a sequence of attempts to provide additional forward guidance on the likely future path of ECB policy and thereby restrain the upside to term rates and the exchange rate of the Euro.

By formulating its guidance only in very general terms, the ECB is not really committing itself in any binding way. However, it is emphasising that it is in an entirely different policy space at present to either the US Federal Reserve or the Bank of England.

In the absence of clearly ‘dovish’ guidance, markets might start to focus on how long it might be before the ECB would begin to withdraw some of its current policy support (as the US Federal Reserve and the Bank of England are now debating). We think this consideration supported the shift to more dovish language today but it falls very far short of a complete explanation.

The fact that the ECB has altered the tone of its press statement today after a ‘rich and ample’ policy discussion is surprising in that Mr Draghi had previously highlighted the importance of the ‘new information’ that became available to the ECB last month. It would seem unusual for the ECB to undertake a fundamental review so soon after it assessed the implications of its new forecasts. It would be even more unusual to alter the policy message unless it felt last month’s message was misunderstood or it was no longer appropriate.

Our guess is that there was some mis-signalling last month by the ECB but it also seems that the fall in inflation from 0.7% in February to 0.5% in March has also caused some soul-searching in Frankfurt. 

A good deal of today’s press conference was taken up with a discussion of the March inflation numbers, the problems posed by very 3 April 2014 3 low inflation as distinct from deflation and the appropriate response on the part of the ECB. Mr Draghi hinted that opinions on the Governing council varied somewhat on these matters even to the point of indicating that today’s statement reflected the consensus view (rather than one agreed unanimously).

He noted that unlike November there are different views within the ECB as to whether the March number altered the medium term outlook for inflation. He went into some detail about the particular influence of the timing of Easter and energy price base effects on the March figure. Mr Draghi admitted that even after these factors were taken into account the reading was lower than expected.

Although the March inflation figure was slightly lower than envisaged, it certainly couldn’t be regarded as wildly surprising. Mr Draghi also noted today that about 70% of the drop in headline inflation in the past two years was due to lower oil prices. It can be argued that this sort of positive supply shock shouldn’t mechanically prompt a policy easing because it boosts spending power but that is not the complete story. It is also the case that ‘core’ inflation (defined as excluding food energy and tobacco) hasn’t been above 2% since December 2002 and has been 1% or lower in each of the past six months.

Subdued underlying inflation has been the norm for some time and, in very broad terms, this is now also associated with constraints on spending power. Indeed, the subdued level of economic activity highlighted in today’s ECB acknowledgement that ‘unutilised capacity is now sizeable’ means there is a real risk that inflation falls short of even the latest ECB forecasts- which themselves represent an undershoot of its official target.

It is encouraging that today’s statement recognises, ‘the risks of a too prolonged period of low inflation’. This is a long overdue shift from an unhelpful concentration on the threat posed by deflation. Unfortunately, Mr Draghi wouldn’t be drawn as to what the ECB might mean by too long or too low in this context. However, we think that if their next set of projections in June entails any downward revisions to the inflation forecasts, it would not be credible not to act.

A further and possibly more immediate source of pressure for additional easing would be any marked strengthening of the exchange rate of the Euro. In the week following Mr Draghi’s slightly hawkish March press conference the trade weighted value of the Euro rose to its highest level in four years. Clearly, this represents a significant threat to a still fragile recovery.

It was not entirely surprising that the April statement strikes a notably different note to that of March and indicates that ‘exchange rate 3 April 2014 4 developments will be monitored closely’. In case there was any doubt in this regard, Mr Draghi introduced into his first press conference the comment stating that the exchange rate was an ‘increasingly important factor in our medium term assessment of price stability’.

If today’s ECB press conference hinted at an increased possibility of further easing, it also attempted to suggest that it had significant capacity in that respect by stating that ‘The Governing council is unanimous in its commitment to using also unconventional instruments within its mandate’. This phrase is remarkable in many ways.

At one level, it should be a given that a Central Bank will use all available instruments. It could be that the ECB is emphasising that it now sees very low inflation as a serious issue (a belated confession?). It might and probably will be taken to mean that previous opposition to quantitative easing within the Governing Council has now ended. Even though QE isn’t specifically identified in the statement, it wouldn’t make any sense to commit to the sort of measures that have already been deployed. The awkward (in grammatical terms) inclusion of the word also is presumably an attempt to emphasise that further rate cuts have not been entirely ruled out. However, it also hints at possible difficulties in arriving at this particular statement.

Interpreted in a particular manner, this ‘unanimous commitment’ might seem like a ground-breaking statement and there is no doubt it pushes the ECB a little further in the direction of QE than some council members would ideally like. However, pressed repeatedly, Mr Draghi was unable to provide any details of what QE might mean in practice. He referred instead to the Banking oriented lending model in the Euro area that means implementing such mechanisms are unlikely to be as straightforward as in the US. This implies any action was still very much at the design stage. In many respects his remarks today in this regard were resonant of those he made initially in relation to ‘Outright Monetary Transactions’. Indeed, the inclusion of the phrase ‘within its mandate’ keeps open the possibility of further significant debate as to what might or might not be permitted.

In summary, we found the content of today’s press conference almost as surprising as that of a month ago although we would interpret many of today’s comments as an attempt to pull back from a tone last month that at very least seemed complacent in terms of the downside risk to inflation. We think the prospect of some Easter related jump in April inflation together with the likelihood of a strong and weather-boosted GDP figure for the first quarter means ECB action may not be immediate. However, subdued inflation and activity datathrough the second quarter mean there could be a further easing in June or July.