- Draghi still keen to keep policy options open as far as possible
- Healthier activity suggests autumn announcement of reduction in policy support
- ECB confidence that inflation will head higher contrasts with latest Fed concerns
- Is today’s FX market reaction to Draghi a form of ‘taper tantrum’?
- Euro exchange rate could become a hot topic in holiday thinned markets
There was little expectation that the ECB would announce any major policy shift today, but there was some anticipation that it might move away from a commitment to step up its asset purchase programme if conditions were to weaken (it didn’t alter this) and there was also the possibility that it would provide some clarity as to when and what actions might be taken to scale back its current ‘very substantial degree of monetary accommodation’ (Mr Draghi set out not to do this either).
In the event, Mr Draghi said little new. While he did promise the ECB would have ‘significant discussions’ on its policy stance in the autumn, his repeated calls for ‘patience and persistence’ suggest a strong desire to prevent the market from anticipating any early or dramatic policy shift from the ECB.
Unfortunately for Mr Draghi, even the not surprising suggestion that policy would be reviewed in the months ahead prompted FX markets to push the Euro higher against other major currencies. Given that Mr Draghi noted that the Euro’s firmer tone of late ‘received some attention’ at today’s Governing Council meeting, a further strengthening of the currency was probably not tintended outcome. There is little question that the ECB wants to give the current upswing in the Euro area more time to strengthen and spread. However, the main reason for Mr Draghi’s caution today relates to persistently low inflation and the risk that a premature policy tightening or the market’s anticipation of such a move would push inflation even further from target. Arguably, the most notable comment from today’s press conference was the ECB president’s assertion that ‘the last thing the governing council wants is an unwarranted tightening of financial conditions that slows down or jeopardises the convergence of inflation’ towards the ECB target.
Unfortunately for the ECB, even a relatively innocuous if upbeat assessment of the Euro area’s economic prospects is likely to strengthen the Euro on FX markets, particularly on a day when the Bank of Japan downgraded its economic outlook and at a time when there is significant uncertainty about policymaking in the US- whether that relates to recent Federal Reserve concerns about below target inflation or broader issues such as Mr Trump’s difficulties in pursuing his domestic legislative agenda. This meant that even though interest rate markets moved little in response to Mr Draghi’s pronouncements, the Euro rose to its highest level against the US dollar in two and a half years.
There is little question that the ECB is increasingly confident about the persistence of the current momentum of activity in the Euro area. As the diagram below suggests, this simply reflects the current reality. If we exclude the early 2015 figures swollen by outsized and unrepresentative step-changes in Irish GDP, the current pace of growth is the strongest in six years.
Today’s press statement recognises this and highlights ‘a continued strengthening of the economic expansion in the euro area, which has been broadening across sectors and regions’. It goes on to refer to a global recovery that ‘should increasingly lend support to trade and euro area exports’. Perhaps of greater significance, it adds to previously cited supports for consumer spending such as employment gains, an additional factor in the shape of ‘increasing household wealth’.
We draw attention to the addition of a reference to wealth effects for a couple of related reasons. First of all, these wealth effects reflect strong and broadly gains in both house prices and equity markets that serve to reinforce Mr Draghi’s contention that ‘financial conditions remain broadly favourable’. Arguably, of greater significance for future policy considerations is that at some point such wealth effects could come to be seen as threatening from a financial stability perspective. This is not to suggest the ECB is currently concerned about these developments but they are clearly on its radar and may eventually encourage a desire to ‘lean against the wind’ by introducing a less expansionary policy stance.
If Mr Draghi was keen to emphasise the good news on economic activity, he was notably more restrained in relation to inflation but, here too, it could be argued that he was perhaps a little less dovish than might have been envisaged. The text of the ECB press statement emphasises that ‘measures of underlying inflation remain overall at subdued levels’ although the addition of the word levels might serve to acknowledge a slight pick-up in core inflation in recent months which is evident in the diagram above. Mr Draghi instead focussed on the current level of inflation, indicating that it ‘is not where we want to be’. However, he also stated the belief that the factors holding back inflation ‘will last for some time’ but they’re ‘not permanent’. He further asserted that the ECB is confident that the inflation will reach its target in light of the strength of growth even if progress is gradual.
In terms of interest rate markets, the ECB’s assessment of the inflation outlook is comforting as it implies the ECB can implement a reasonably slow and orderly pace of policy adjustment. Again, however, from an FX market perspective, the confidence with which Mr Draghi set out his expectations for modestly higher inflation stands in clear contrast to today’s revised Bank of Japan projection that now sees its inflation target being hit during fiscal 2019 rather than 2018 as it envisaged three months ago.
It could also be argued that Mr Draghi’s assessment is more confident in tone than several recent pronouncements from the US Federal Reserve that reflect a measure of surprise at a softer trend in US inflation of late. For these reasons, it is not entirely surprising that the exchange rate of the Euro has moved higher today although the scale of move likely owes something to holiday thinned trading conditions in FX markets.
How enduring today’s currency moves prove to be and whether market interest rates follow may depend on how investors eventually assess Mr Draghi’s indication that the ECB would have ‘discussions in full’ on the economic and inflation outlook as well and the implications for policy ‘in the autumn’ . In response to a persistent line of questioning, he refused to clarify whether this timeframe referred to the ECB governing council’s next policy meeting on September 10th, nor would he provide any guidance on what specific policy options might be considered at that point. He repeatedly answered that the ECB had not discussed when or what the ECB might alter its current stance or even signal an intention to do so. Clearly, Mr Draghi is eager to keep all options open for now.
Our sense is that upcoming data are likely to confirm the increasing strength of the upswing in activity and may also suggest a tentative firming of inflation. In such circumstances, it could be expected that, at its September meeting, the ECB would signal an intention to taper, or in its language to ‘recalibrate’, its asset purchase programme and Mr Draghi could even provide some indications in this regard when he speaks at the high profile Federal Reserve Jackson Hole conference in late August. Of course, a more uncertain backdrop could push these announcements back to the following ECB governing council meeting on October 26th.
In the interim, however, the ECB is likely to pay even more attention to the performance of the Euro on FX markets. ECB research suggests that a 1% change in the currency alters inflation by about 0.1% in the opposite direction within twelve months and by about 0.3% over three years. This would threaten to push inflation further away from the ECB’s target. Of course, the restraint offered by a higher exchange rate would be partly offset by the boost coming from stronger growth at present but, on balance, inflation would likely stay uncomfortably below the ECB’s desired level.
More immediately, we have a strong sense that the ECB may be experiencing a bout of ‘taper tantrums’ today. However, unlike the US precedent in 2013, this is being seen in the potentially more volatile and more difficult to manage FX markets rather than in the bond market. Mr Draghi and his colleagues may not get the quiet summer they so clearly want.
