Policy rates were left unchanged

 ECB Doesn’t Ease And Fails To Give Clear Signal

• Risks Still To Downside But Mr Draghi A Little Less Downbeat

• ECB Presents Slightly Awkward Defence Of Inaction

• Upcoming Inflation And GDP Data Important, New ECB Projections Critical

• We Think Easing Likely In March Unless Economy Or Inflation Take Of


While opinion was divided as to whether the European Central Bank would cut its key interest rates today, it was widely expected that ECB president, Mario Draghi, would at very least strongly signal the prospect of a further policy easing as well as provide some sense of precisely what form this easing would take

Unusually, Mr Draghi disappointed these expectations and by quite some distance. Policy rates were left unchanged and, although Mr Draghi reaffirmed that the ECB was willing and able to act decisively, he failed to provide the explicit commitment to further easing that many had expected.

Mr Draghi did note that the ECB remains focussed on downside risks and the circumstances or ‘contingencies‘ in which these risks might materialise. For markets anticipating clear guidance, this may have suggested that a further move was not as close as anticipated. According to Mr Draghi, there had been a ‘broad discussion’ today that focussed largely on the need for additional information because of ‘the present uncertainty’. Time and again, he used the word ‘complex’ to describe the issues now being assessed by the ECB as it debates what to do next.

It is not surprising that markets were disappointed today and, at the margin, the ECB may not be unhappy to push back against any growing sense that, under Mr Draghi, there will simply be a reflex policy response to any disappointing news on inflation. However, we think the pressure for a further easing is continuing to build.

A Big Month For The Euro Area And The ECB

In the next month, a number of factors are likely to decide when and how the ECB acts. First of all, preliminary February inflation data may help show whether recent unexpected weakness is an aberration or a threatening trend. Second, provisional GDP data for the fourth quarter may indicate what sort of momentum is building in activity. Third, we may be a little clearer as to whether recent turmoil in emerging markets and even some wobbles in certain US indicators of late are a temporary concern or something more sinister. Our guess is that greater clarity on these issues is required to build a solid consensus on the appropriate policy response by the ECB.

In this context, next month’s new staff ECB projections are likely to play a key role, in part because they serve to formalise thinking on the influence of these diverse factors. More importantly, we think it is very significant that these projections will incorporate the ECB’s first estimates for inflation and activity in 2016. This is an important new departure as previously the ECB has tended to focus its projections on the current and following year.

The new projections should show the extent to which trends in prices and output might be expected to return to healthier levels over the next three years. Research suggests it typically takes two to three years for policy changes to build to their full effect on inflation. Indeed, Mr Draghi noted today that these ‘lags’ have tended to come down in recent years (earlier ECB research suggested that the full impact might not be seen for four or five years). So, the March projections will indicate whether the ECB staff thinks the current policy setting will be adequate to deliver a return to the target of an inflation rate ‘below but close to 2%’ over its policy-relevant horizon.

Is Current Inflation A Problem?

With money market tensions a little less threatening of late, the main focus at least for now in terms of whether or not to alter policy relates to the prospects for inflation and the associated outlook for the Euro area recovery. In recent days, newswire reports suggested divisions in ECB thinking about the economic outlook and the implications for policy. There are several hints at such a possibility or at least a substantial degree of uncertainty in today’s press statement and comments.

One area, however, where Mr Draghi was clear was that the ECB sees little or no signs of deflation at present. To the extent that this extreme risk is avoided, the ECB is likely to feel it can be a little more measured both in term of the scale and timing of any policy response.

Speaking more generally about inflation, Mr Draghi outlined a number of reasons which might suggest that the ECB is not all that concerned about the current rate of inflation in the Euro area. He said that the current Euro area experience was not that different from that in previous periods such as the wake of the Asian crisis or in the aftermath of Lehman’s. He also suggested it was not all that different to inflation in the US at present.

Mr Draghi then went on to highlight the role being played by weakness in food and energy prices. Aside from the fact that the ECB has traditionally emphasised headline inflation above other adjusted measures, a comparison of the most recent figures for headline inflation (+0.7%) and excluding energy, food, drink and tobacco (+0.8%) doesn’t suggest any dramatic difference. He also noted the impetus to lower inflation from ‘programme’ countries of Greece, Ireland, Portugal and Spain. However, he carefully avoided any response to a question in relation to recent trends in France (+0.7%) and Italy (+0.7%).

Mr Draghi did acknowledge the role being played more generally by weakness in demand in weighing on inflation but added that activity was now moving in a positive rather than negative direction. While there is some measure of truth in all of these arguments, they seem like a rather strained attempt to defend today’s inaction rather than an entirely coherent description of the current inflation landscape. Our own sense is that at very least current inflation is warning of the risk of a nasty equilibrium (in the sense that there is no automatic tendency to change) of persistently weak activity and inflation. 

ECB Slightly More Optimistic On Growth?

One factor that may be influencing the thinking of some ECB officials in term of the future trajectory of inflation is recent evidence suggesting that a recovery in activity is continuing to take hold. Admittedly this evidence is fairly patchy as today’s releases of extremely weak Euro area retail sales and disappointing German orders data underline.

Today’s ECB press statement is unusual in that the first comment notes that ’incoming information confirms that the moderate recovery is proceeding in line with our previous assessment’. This positioning, rather than the usual primacy given to a discussion of inflation, could reflect a sense that because the economy might now be set on a reasonable trajectory, the case for further easing is no longer as pressing.

Similarly awkward references to a slightly less problematic economic environment appeared today in the shape of the caveat that unemployment is stabilising even if it remains high and Mr Draghi’s calculation that when corporate bond issuance is added to bank lending flows, credit flows overall were ‘ closer to zero’ of late. There is little doubt that there are some conflicting signs as to the current health of the Euro area economy. However, today’s press conference tended to emphasise rather tenuous areas of improvement.

While Mr Draghi re-iterated the persistence of downside risks to activity and acknowledged the additional threat posed by recent turmoil in emerging markets, the balance in his comments today was somewhat at odds with most of his recent analyses. Again, we have the impression that these sorts of comments were designed both to justify today’s inaction as well as to highlight the sort of trends in data in the coming month and in the upcoming ECB projections that would be decisive in prompting a policy change.

Pressures For Action Persist

We still think event in the past months have altered the outlook for activity and inflation to the point that a further ECB policy easing will be required. The coming month will decide precisely what form this is likely to take but a 10 or 15 basis point cut in the refi rate accompanied by some additional measures such as a cut in reserve requirements would not be surprising.

Our sense from the tone of today’s ECB comments is that there is some opposition on the governing council to more radical moves. In the absence of unexpectedly good news on the Euro area economy, this means that markets could remain focussed on the possibility of further ECB easing for some time to come.