Thursday, February 6, 2014

Recovery hopes win from deflation fears (at least for now)

The ECB kept its powder dry at today’s meeting. As expected, it must have been a very close call but eventually the ECB followed the old saying ‘if in doubt cut it out’. However, during the Q&A session, ECB president Draghi stressed the ECB’s determination to act again if money market tensions would increase and/or the medium-term inflation outlook worsens. Postponed is definitely not abandoned. As regards the ECB’s macro-economic assessment, the base case scenario still seems to be intact. The ECB still expects a gradual recovery, mainly supported by domestic demand, improving financing conditions and a gradual pick-up in global activity. Risks to this outlook are still to the downside, with recent financial market turmoil and uncertainties in emerging economies being a new risk factor. As regards inflation, the lower-than-expected headline inflation in January did not change anything. The ECB still expects a “prolonged period of low inflation, which will be followed by a gradual upward movement towards inflation rates below, but close to, 2% later on”. Ahead of today’s meeting, new speculation about imminent ECB action had emerged, mainly driven by the latest drop in headline inflation and the continued subdued recovery. Since the last rate cut in November, many market participants and observers had re-interpreted the ECB’s reaction function, expecting a direct link between movements in headline inflation and ECB action. Today’s decision showed that this direct link does not exist. Instead, Draghi presented at least two interesting insights in the ECB’s current way of thinking. The first remarkable change was in the introductory statement, which for the first time in a long while started by stressing the recovery and only then moved to inflation developments. In our view, the best explanation why the ECB did not act today. At least today, recovery hopes won from deflation fears. The second remarkable detail was Draghi’s announcement that the ECB staff projections in March will for the first time ever present numbers for t+2 (ie two years ahead). While former ECB-president Trichet had invested lots of effort into the ECB’s predictability – just think of the famous code words – his successor Draghi had recently more problems in getting his meassage across. Today’s meeting should have helped in finally explaining the ECB’s current reaction function. In our view, only a significant increase in money market tensions and/or a worsening of the medium-term inflation outlook will trigger further action. In this respect, the March meeting with the presentation of the staff projections will indeed be crucial. Remember that in December, ECB staff had predicted an average inflation rate of 1.3% for 2015. A lower number for both 2015 and 2016 would clearly open the door for more ECB action. What could this ECB then actually be? By now, the options are well-known and are in theory fully-fledged QE (eg, by purchasing SME loans), conditional liquidity through, for example, a funding for lending scheme or another refinancing rate cut and a negative deposit rate. However, in practice, both a funding-for-lending scheme and fully-fledged QE are still hard to implement. With full allotment still in place (and will be until 2015), it is hard to see how banks could subscribe a new conditional liquidity provisions. Moreover, the positive experience from the UK was mainly concentrated in the mortgage market; probably not the ECB’s biggest concern. Fully-fledged QE is also easier said than done as it would have to focus on SME loans and not government bonds. Given the practical difficulties and Draghi’s comments at today’s press conference, we still think that any next step would be a rate cut, rather than more unconventional measures. All in all, today’s meeting in our view made clear that the door for further monetary policy action remains open. Draghi’s downplaying of an outright deflation risks, however, suggests that the ECB would still like to refrain from all-or-nothing measures, keeping another rate cut as the most likely next step. But for the time being the ECB seems to bank on a long period of low status quo.

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