Draghi gives dovish present on his birthday

What a difference only a couple of months can make. Remember that back in March and April, the ECB was very upbeat on the Eurozone economy, with ECB president Draghi obviously enjoying the positive impact from QE (and even its pure announcement effect)? Now, just a couple of months later, the ECB has become less upbeat. After today’s ECB meeting, president Draghi sounded rather dovish, keeping the door for stepping up QE open. The somewhat more downbeat economic assessment is mainly the result of weaker growth in emerging markets. The ECB still expects a gradual recovery, albeit at a somewhat weaker pace. This was also reflected in the latest ECB staff projection, which foresee GDP growth to come in at 1.4% this year (from 1.5% in the June projections), 1.7% in 2016 (from 1.9%) and 1.8% in 2017 (from 2.0%). As regards inflation, ECB staff projections were revised downwards significantly on the back of lower energy prices. In the latest projections, ECB staff expects inflation to come in at 0.1% this year (from 0.3%), 1.1% in 2016 (from 1.5%) and 1.7% (from 1.8%). All these projections, however, have to be taken with a large pinch of salt as the cut-off date was much earlier than usual and therefore before the peak of latest market turmoil. Normally, the cut-off date of ECB staff projections is around the 20th of the month, now it was the 12th. The early cut-off date is an additional explanation for the ECB’s caution and new emphasis on downside risks. As regards the ongoing QE programme, the ECB announced that it would increase the so-called “share issue limit” from initially 25% to 33%. This decision was taken after a first assessment of the first six months of QE and means that the ECB could now purchase up 33% of each government bond issuance (as long as this would not give the ECB a blocking minority). While some market participants saw this measure as a first step towards stepping up QE, it is in our view a more technical measure, reflecting the fact and fear that the ECB could run into troubles achieving its monthly target of 60bn euro. Needless to say that the drop in inflation projections has revived the deflation versus disinflation debate within the ECB. It is the same debate the ECB had at the end of last year when discussing the need for QE. It is the debate on whether low or negative headline inflation rates, mainly triggered by dropping energy prices, do lead to deflationary expectations or are simply a blessing for the economy, increasing consumers’ purchasing power. In today’s comments, Draghi suggested that currently the ECB was still tending to the “it’s a blessing” explanation. Still, Draghi made two important comments which in our view set the door for more QE a bit more open: the small addition of “or beyond” to the targeted duration of September 2016 for the QE programme and the phrase that the Governing Council emphasized its “willingness and ability to act, if warranted, by using all the instruments available within its mandate and, in particular, recalls that the asset purchase programme provides sufficient flexibility in terms of adjusting the size, composition and duration of the programme.” The door to more QE is open, even if Draghi also stressed that the ECB today had not discussed this possibility, but will the ECB also walk through this door? To answer this question, one has to go back to the initial QE discussion in late 2014. In our view, back then the deflation threat was a welcome stalking-horse to convince even die-hard monetarists in the Governing Council to sign off QE. Of course, successful QE would eventually also increase inflation and inflationary expectations but only indirectly and as a second round effect. The main and most imminent impact from a successful QE would go through a weaker exchange rate and stronger economic growth. Keeping this in mind, lower inflation projections will not per se lead to an increase of QE. To really see the ECB stepping up QE, the Eurozone recovery would need to falter first. On his birthday, Mario Draghi did not receive but actually gave a present to financial markets, stressing the ECB’s determination to do everything to support the Eurozone economy.