ECB starting to prepare its first steps towards tightening?


Slightly less dovish tone from Draghi

Subtle changes suggest ECB beginning to think about exit strategy

No early tightening in prospect but ‘noisy’ period could be beginning

Buoyant economy and expected inflation pick-up to alter policy stance

Draghi suggests data pointing towards mid-2019 rate rise 

The ECB’s January meeting is rarely an occasion for fireworks and ECB president, Mario Draghi, suggested yesterday that ‘very little has changed’ since the ECB provided its previous update and its latest economic projection in mid-December. Howeverthe substance of his comments appears to contradict that verdict and hint that an important change in thinking may be underway in Frankfurt.

The ECB did seek to limit the rise in the exchange rate of the Euro by emphasising in the opening press statement that ‘the recent volatility in the exchange raterepresents a source of uncertainty which requires monitoring’. This is definitely a source of some concern. However, it doesn't appear to be the central focus for the ECB at present. The more important message from Mr Draghi yesterday was one of increasing confidence in the economic upswing and the start of considerations as to what this will mean for ECB monetary policy.

While Mr Draghi strongly indicated that any notable policy change is still some distance away, the tone of his remarks suggested the ECB is beginning to contemplate what is likely to be quite an extended process of phasing back the degree of monetary support for the Euro area economy.

Important but not entirely surprising was Mr Draghi suggestion that discussions are beginning as to exactly how and when to phase out the ECB’s Asset Purchase Programme.  It was more surprising that he gave a fairly unambiguous response to a question on the possible timing of a first ECB rate rise when he indicated that on the basis of current trends in economic data, an initial rate rise might be seen in mid-2019.    

A not so dry January for Mr Draghi

In one sense Mr Draghi’s encouraging tone yesterdaymight simply be seen as an acknowledgement of a sustained period of very strong growth in the Euro area economy through the past year. With momentum in activity and employment continuing to building forcefully, markets increasingly judge that the degree of monetary policy accommodation provided by the ECB’s current stance is no longer required. However, when and exactly how an exit path might be negotiated remains unclear. Mr Draghi’s remarks yesterday suggest that a discussion of the key details of that exit process is now starting to appear on the Governing council’s agenda.

Mr Draghi described how despite the ECB's judgement that little had changed of late, it had observed that the expected path of short term interest rates had moved up and exchange rate volatility had increased. He then suggested three factors might be at play; an improvement in the economy, a heightened market sensitivity to perceived changes in ECB communications and finally, in the case of the exchange rate, what Mr Draghi effectively described albeit in slightly more diplomatic language as inappropriate comments on the dollar by US policymakers.   

On the first of these factors, yesterday's opening press statement hints that the ECB’s assessment of current economic conditions is being progressively upgraded. Like most other forecasters, the ECB is playing catch-up in relation to the strength of the Euro area economy. Its statement acknowledges that the upswing in the Euro area economy ‘accelerated more than expected in the second half of 2017’ and adds ‘increasing capacity utilisation’ to a list of factors that ‘strengthen further our confidence that inflation will converge towards our inflation aim..’ . The tone of these remarks implies that the ECB now has a notably stronger conviction that Euro area economic conditions have moved onto a notably firmer trajectory of late.

A stronger economy has implications for ECB policy

Mr Draghi went on to say that changing economic conditions would be reflected in monetary policy; ‘Naturally as the economy improves, this will accompany quite neatly our monetary policy.’  He said this would occur in a clear sequence with the emphasis initially falling onto reinvestment of maturing securities when the current phase of net asset purchases ends and eventually onto forward guidance on interest rates which he highlighted now emphasised that rates would remain at current levels ‘well past’ the ending of net asset purchases.

Mr Draghi acknowledged that markets would favour some explicit guidance in terms of timelines but argued that ‘discipline’ was required in ECB communications at this point in time. He then indicated a discussion at the Governing council would determine whether September would see another extension of the Asset purchase Programme, an abrupt end to the programme at that point or a further tapering. As this seems to represent at least the possibility of a climb-down from his December press conference comment that ‘it's never been our view that things should stop suddenly’, it seems consistent with the view that the balance of thinking is shifting,  even if modestly, within the ECB.

Although Mr Draghi was circumspect in relation to many aspects of the policy outlook he was more forthright when asked if he would endorse Bundesbank president’s Jens Weidmann’s view that mid-2019 was a likely time for an initial rise in ECB policy rates. Mr Draghi answered that the ECB is effectively data dependent in relation to its policy decisions and that basically that’s what the data tell us’.

Implicit in this response is a reasonably clear timeline for the start of the initial phase in the ECB’s exit strategy which suggests that, in the absence of a marked change in the expected trajectory of activity and inflation, the Asset Purchase Programme will effectively finish in the autumn and the groundwork will be laid for a first rate rise in the summer of 2019. As Mr Draghi again emphasised yesterday the ECB’s monetary policy stance will remain accommodative well after the first rate hike. In this respect, he is completley in tune with market thinking which is firmly of the view that the path to ‘normalisation’ will take even longer on this side of the Atlantic than it has in the US.

Draghi subtly starts to prepare markets

The second factor that Mr Draghi referenced yesterday as a likel driver of recent market movements was a ‘heightened sensitivity’ to the possibility of a change in ECB thinking. We think this has come about because markets increasingly take the view that the present stance of ECB policy looks increasingly ill-suited to current economic conditions.

In such circumstances, there is an understandable fervour to be positioned properly ahead of any alteration in ECB policy. We think the general tenor of Mr Draghi’s remarks confirms at very least a shift in focus towards the need to prepare markets for the process of scaling back the degree of monetary support being provided to the Euro area.  By extension, this would tend to validate the markets recent reaction to the comments of various ECB officials.

In view of markets increased sensitivty to ECB comments, Mr Draghi outlined three elements that we think might be important considerations for the ECB in framing its exit strategy. The first element he mentioned was confidence. Clearly, there is now much greater confidence in the persistence of strong economic conditions in the Euro area and this is encouraging greater confidence that inflation will gradually move towards the ECB targetHowever, a second element, patience, will also be crucial as a pick-up in inflation is not yet evident and may take some time to materialise. Finally, Mr Draghi noted the importance of persistencein that ECB policy is likely to remain notably supportive well after what is expected to be an extended normalisation process has begun.

There is little question that markets share the ECB's growing confidence in the economic outlook. Significantly, however, Mr Draghi’s emphasis on patience and persistence may reflect a worry that markets will move too far and too soon. the ECB’s is very anxious to avoid a premature or excessive uptick in market interest rates or the exchange rate of the Euro.

Mr Mnuchin’s comments are a problem but the Euro presents a greater dilemma for the ECB

Mr Draghi’s clearest expression of concern yesterday related to exchange rate movements that stemmed from what he called ‘the use of language… agreed at the IMF’. While he didn’t specifically refer to comments made by US Treasury Secretary Steve Mnuchin who was quoted on Wednesday as saying that that a weaker dollar was "good for us as it relates to trade and opportunities", it is clear that such rhetoric is raising some concerns within the ECB.

While Mr Draghi may feel that he needs to protest strongly against any US actions to talk down the dollar, we think the broader tone of yesterday’s press conference suggests the ECB is more focussed on the ongoing strengthening in the trajectory of the Euro area economy. This momentum in activity would make it very difficult to prevent some degree of appreciation of the Euro. Indeed, Mr Draghi acknowledged this by indicating today that exchange rate gains in response to favourable economic developments were ‘part of nature’.

A key uncertainty for markets and for the ECB itself is how much of the rise in the Euro is simply a reflecton of improved Euro area fundamentals.  Mr Draghi hinted that opinion may be quite divided at the ECB as to exactly how miuch of an impact a rising Euro will have on inflation in current circumstances. If that rise is largely driven by a more buoyant Euro area economy, that buoyancy may limit any disinflationary impact of the rising exchange rate.

Less dovish Draghi prepares to guide in March?  

The fact that term interest rates are firmer and the Euro rose in the wake of the ECB press conference suggests that Mr Draghi was less dovish than had been expected. This may reflect a recognition by the ECB that to avoid an excessive future tightening in financial conditions in the Euro area it needs to progressively modify its message and prepare markets for what it likely hopes to be an orderly and extended path towards policy normalisation. Alternatively, the slightly altered message may simply reflect the increasing influence of longstanding hawkish voices.

The likelihood is that markets will expect a clearer indication of the intended policy path at the March policy meeting and some pointers in this regard in the interim. Mr Draghi has now sketched out some important parameters by suggesting that mid 2019 might be represent a plausible timing for a first rate rise. However, as he also suggested that the exact nature of the wind-down of asset purchases has yet to be decided, there may be scope for further significant volatility in interest rate and currency markets in the weeks ahead.  

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