- Fading political uncertainty implies the way has been paved for more hawkish communication from the ECB at the meeting in June, bringing renewed market focus to the ECB’s exit strategy.
- The ECB has many other options than removing the ‘or lower levels’ phrase in its forward guidance on policy rates and in order to avoid a tightening of financial conditions a more cautious approach seems likely.
- The ECB’s key challenge is a lack of wage pressure and as long as there are no signs of improvement in the underlying price pressure, the ECB seems to stick to its policy stance in terms of policy rates, QE purchases and forward guidance.
Market’s attention could again turn to the ECB’s exit strategy
The political risk in the euro area has been reduced considerably with Macron winning the French presidency and market’s attention could again turn to the ECB’s exit strategy. In our view, the way has been paved for a more hawkish communication at the next meeting on 8 June when the ECB will also have the next inflation print for May and updated inflation projections. In our view, a more hawkish wording should not be seen as a sign of near-term actually tightening. Instead, it should reflect there are a lot of soft words in the introductory statement (see next page), which need to be taken out gradually before actually tightening the monetary policy. Related to this, we still believe the ECB will extend its QE purchases by EUR40bn per month going into next year as the underlying price pressure remains weak. This also implies it is premature to believe in rate hikes any time before 2019, in our view.
There has been a lot of discussion about whether the ECB will change its forward guidance on policy rates and remove the ‘or lower levels’ phrase at the upcoming meeting in June. The Governing Council discussed such a change at the meeting in March after which the market priced in a 10bp deposit rate hike from the ECB already this year. If the ECB makes this change to its forward guidance, it is likely to have considerable market implications with the pricing of policy rate hikes again being moved forward. However, such a price action does not seem to be what the ECB wants already, as the communication from prominent ECB members turned much more dovish in an attempt to dampen the speculation about rate hikes after the meeting in March.
Another argument against the ECB changing its forward guidance should be that the ECB communicates it has not seen sufficient evidence to change its assessment about the inflation outlook. Related to this, Draghi has said that ’before making any alterations to the components of our stance – interest rates, asset purchases and forward guidance – we still need to build sufficient confidence that inflation will indeed converge to our aim’. Hence, the question should be whether the reduced political uncertainty changes the ECB’s inflation outlook. While there could be some positive impact on economic sentiment and hence activity, the past year’s experiences are that the economic situation is resilient to political uncertainty. Added to this, a better economic outlook is not yet enough to generate higher underlying price pressure as there is a large amount of slack in the labour market. In light of this, it is key for the ECB to get wage growth up, see Euro area wage growth should stay subdued, not supporting core inflation significantly..
The ECB has other options than changing forward guidance
Instead of changing the forward guidance when it remains unclear whether the inflation outlook has improved, the ECB is in our view more likely to again remove some of its dovish wording. So far this has been the strategy from the ECB, as it at the meeting in March removed a sense of urgency in taking further actions as the introductory statement no longer included ‘if warranted to achieve its objective, the Governing Council will act by using all the instruments available within its mandate’. Likewise, at the meeting in April the ECB moved in a slightly more hawkish direction as it described the risks surrounding the growth outlook as still being tilted to the downside but moving in a more balanced configuration after characterising these downside risks as being less pronounced in March.
Hikes are premature as the ECB will follow its forward guidance
We have continuously argued it is premature to price hikes from the ECB as we expect the ECB to stick to its sequencing entailed in the forward guidance, thereby not hiking rates before having ended QE. Given our expectation of a QE extension of at least six months this should at the earliest happen in the second half of next year. In line with this, prominent ECB members have recently attempted to explain the reasoning behind the sequencing of the exit strategy. In a dovish speech Draghi argued that ‘in a multi-country monetary union such as the euro area made up of segmented national financial markets, asset purchases are inevitably more difficult to calibrate, more complex to implement and more likely to produce side-effects than other instruments. So it is natural that we turned to them only after other, more conventional options were becoming exhausted. Similarly, lowering interest rates into negative territory in a largely bank-intermediated financial system was a step into uncharted waters’. Along the same lines, ECB’s Chief economist Peter Praet argued that ’our policy instruments act as strong complement. For instance, the downward pressure that APP exerts on term premia is strengthened by the negative interest rate policy and the rate forward guidance that offers an expected horizon for continuing that policy in the near term’.
An argument behind the speculation about ECB hikes could reflect a perception that the ECB felt a need to support the banking sector, which should be suffering after the long period of negative policy rates. However, the ECB does not seem to consider bank profitability as a big problem as Draghi has recently said: ‘As household deposit rates have been sticky at zero, banks’ net interest rate margins have fallen somewhat. However, the impact on bank profitability has been offset by the positive effects of easier financial conditions on the volume of lending and the reduction in loan-loss provisions, as monetary policy has lifted economic prospects’. During the latest press conference he reiterated this message by saying that ‘the negative rates in conjunction with the other elements of our easing package have turned out to be powerful in terms of easing financial conditions and the potential negative side effects have so far been limited.”
A question remains whether the ECB could later change its sequencing strategy. On this issue executive board member Benoît Cæuré said: ‘The choice of sequencing of policy instruments will be the outcome of our regular assessment of the medium-term price stability outlook, reflecting the state-dependent nature of our expectations of the horizon over which our policy instruments are likely to be maintained’. However, his view is not shared by Praet who later said: ‘A deviation from the path of policy that is consistent with our past communication is not only costly in terms of policy credibility in general. It would also scale back an important source of stimulus that is behind the performance of the economy that we observe today’.
