Weaker forecasts and downside risks suggest outlook more worrisome.

Verbal easing today will weigh on the euro.

Step-up in QE to follow if growth and inflation weaken further.

Amount of additional QE needed could be substantial, possibly an extra €500 billion?

ECB president Mario Draghi was widely expected to strike a dovish tone in the press conference that followed today’s regular policy meeting of the ECB’s Governing Council. However, his comments suggested the ECB may be more willing to contemplate further policy easing than markets envisaged.

The ECB has revised down its assessment of the outlook for both Euro area growth and inflation for 2015, 2016 and 2017 (see details at the end of this note). While the scale of these revisions is relatively modest, the continuous and cumulative downgrading is not insignificant. Possibly as important, Mr Draghi acknowledged that developments since the mid-August cut-off for the new projections meant that there were ‘renewed downside risks’ to the outlook.  So, the ECB is highlighting both the current reality of a weaker trajectory for growth and inflation than it previously envisaged and the clear risk that its latest assessment may still prove too optimistic.

Euro Could Be Pressured As Draghi Says ECB Ready and Willing To Ease If Necessary 

Importantly, the ECB also signalled a strong commitment to ease policy further if these downside risks materialise. The opening press statement: ‘… emphasises its willingness and capacity to act, if warranted, by using all the instruments available within its mandate and, in particular, recalls that the asset purchase programme provides sufficient flexibility in terms of adjusting the size, composition and duration of the programme’.

In this respect, today’s comments emphasise a clear easing bias in ECB policy that is more pronounced than markets envisaged and also strongly at odds with the current stance of  monetary policy in both the US and UK. As a result, the most immediate impact may be seen in currency markets where the Euro could come under significant pressure, particularly as Mr Draghi also emphasised the importance of the exchange rate to growth and inflation prospects for the Euro area.

Evidence of Lasting Problems Required For Action

While today’s ECB pronouncements represent quite an aggressive verbal easing, clear evidence of a further weakening in the economic outlook will be required to prompt additional Quantitative Easing measures. The volatile and recent nature of fluctuations in financial markets means ‘the Governing Council judged it premature to conclude on whether these developments could have a lasting impact…or whether they should be considered  to be mainly transitory.’   This means the ECB policy outlook will become increasingly data dependent. However, final judgement in this regard may be heavily influenced by thinking as to whether the next set of ECB projections is likely to be revised up or down. So, markets may see further ECB action as more probable in December than in late October.

Mr Draghi also indicated that the Governing council hadn’t discussed what form any potential further ECB easing would take. As various ECB comments have effectively ruled out any further cut in official interest rates, the issue seems to be whether it would entail an increase in the amount of assets purchased, the type of assets purchased, an extension in the time frame of the programme or some combination of these elements.

ECB Asset Programme Might Need Significant Boost

Our sense is that a significant weakening of the inflation outlook (one that might shave an additional 0.2-0.3 percentage points from the current forecast) would probably require a range of responses. Extending the time frame of the programme would have no immediate impact on inflation and would risk allowing expectations of uncomfortably low inflation to become embedded. This means an extension of the programme would work better if inflation was making slower than expected progress towards target than if the ECB judged the outlook for inflation to be persistently lower. The bank-centred nature of Euro area financial markets means that the range of additional domestic assets of adequate rating that might be purchased is quite limited while there would be significant internal and external resistance to any idea of substantial purchases of non-Euro assets. For these reasons, the emphasis would probably be on a marked rise in the size of monthly asset purchases.

Some sense of the scale of action that might ensue is suggested by the following rough exercise; previously reported ECB research suggested that €1,000 billion in asset purchases would boost inflation by somewhere between 0.2-0.8 percentage points. So, the likelihood is that up to €500 billion of additional asset purchases would be required to offset a further inflation downgrade of 0.2-0.3 percentage points. One possible way of achieving this would be to boost purchases by about €20 billion per month from next January and to extend the programme by four months into early 2017.

While we present these numbers as purely illustrative, they suggest that if the downside risks highlighted by Mr Draghi today were to materialise, a substantial increase in the asset purchase programme might be required to drive inflation back to the ECB’s target. Indeed, the worst possible outcome would probably be an increase in the programme that is too small to materially affect inflation or to cause ‘shock and awe’ in markets because of the associated threat to ECB credibility. These considerations suggest any action would need to be significant. This would likely weigh heavily on the exchange rate of the Euro and also act as a significant ceiling on Euro area bond yields.

Technically, the capacity of the ECB to act on this scale would present challenges. One constraint is the limits the ECB has imposed on both the amount of each country’s (or institution's) bonds and the amount of any specific bond it can purchase. In this context, the ECB announced today its decision to increase the ceiling on the amount of any specific bond that it can purchase from 25% to 33% of the amount issued. It can be argued that this is simply a technical measure that follows a promised six month review of this element of the asset purchase programme. It is also the case that this increase in the issue limit (for specific bonds) simply brings it into line with the issuer limit (for individual countries and agencies).  However, this change serves to underline a willingness and capacity to scale up the size of monthly asset purchases if needed.

Forecast Downgrade Modest but Worrisome

The starting point for Mr Draghi’s dovish stance today is a downward revision to the ECB’s projections for economic growth and inflation. As the table below indicates, the magnitude of the revisions is not dramatic but the fact that previous forecasts for both growth and inflation for all three years of the projection have been cut points to a lasting weakening of the economic outlook. The fact that the reduction in growth for 2017 is as large as that for 2016 also hints at a persistent problem.

As the ECB indicated, the ‘somewhat weaker pace than earlier expected’ is due in particular to the slowdown in emerging market economies. As a result, the downgrading is largely seen in weaker Euro area exports. However, while consumer spending is marked up marginally--presumably due to lower oil prices, employment growth is marked down somewhat for both 2016 and 2017.

The ECB also marked down its inflation forecasts materially for 2015 (as the table shows) and Mr Draghi acknowledged that headline inflation could dip below zero in the next couple of months. Of greater importance to the policy outlook is the notable pullback to its 2016 projection. Although this is entirely due to weaker energy and food prices, there may be risks that this spills into a lasting reduction in inflation. This may be hinted at in weaker employee compensation in 2016 and 2017 and a marginal drop in the ‘core’ inflation rate in 2017 from 1.7% to 1.6% that might suggest some difficulties in returning inflation to a sustainable path consistent with the ECB’s target.




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