ECB Disappoints; Dovish Rhetoric Lost in the Noise

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The European Central Bank (ECB) did announce some easing in their monetary policy today, but disappointed the market who were expecting more after the extremely dovish communications which have built up since September. ECB President Mario Dragi managed to disappoint on both the depo rate and the QE part of the easing package, and markets have responded accordingly. Whilst Draghi did maintain a dovish rhetoric in light of continued downside risks to inflation, this was lost in the noise of the disappointment.

ECB Actions

Deposit rate cut to -0.3%, from -0.2% previously. The market was looking for a 15bp cut, whilst 10bp was our call – hence the slight hawkish surprise. The main refi rate stays just positive at 0.05%, so the policy corridor has become asymmetrical. It appears the ECB wants to keep some depo rate cuts in reserve as Draghi didn’t close the door to further depo rate cuts.

Draghi made several changes to the QE program, although only really the six month extension in the purchase timing (extended from September 2016 to March 2017, EUR360bn in extra purchases) matched expectations. The other changes include: a) buying of regional debt (mainly reduces the risk of bottlenecks in buying German assets, other countries less affected) , b) reinvestment of maturities (as per other central banks) and c) continuation of LTRO. We shall need technical details to fully anticipate quite how many extra bonds are bought under a) and b) but it is unlikely to materially impact purchases – and comes in the midst of market expectations which were looking for an extra EUR10bn of purchases every month.
Why did the ECB disappoint? The ECB noted that QE to date has worked, and indeed they were doing more of the same preciously due to that. Draghi did of course leave the door open to further easing if required by the ECB’s forecasts in future – most likely in the depo rate area.

ECB Forecasts

Growth forecasts were upgraded for 2015 and 2017, whilst inflation forecasts for 2016 and 2017 were downgraded. It would now appear that we need at least a 1.5% or lower y/y inflation print for 2017 for the ECB to be significantly spurred into further action .
These forecasts were accompanied by the dovish rhetoric that risks to inflation were on the downside, even after these measures.

Looking beyond the headline number, Draghi noted that consumption was likely to be a stronger driver of growth going forward – although this will have to overcome the fact that base effects related to oil will disappear in coming periods – reducing the impetus for additional household consumption. There was also a change in view on fiscal policies, with the fiscal stance now viewed as supportive following the 2016 budgets approved by the EC.

Looking Ahead

Base effects relative to oil and food prices mean that inflation is expected to pick up in Q1 2016, approaching CPI at 1% y/y by mid-2016. If this doesn’t materialize – perhaps due to weak price growth in services and industrial prices, a significant rebound in the EUR or a derailment in the recovery – this will likely see calls for further action from the ECB. Such calls could occur as early as March 2017 when the ECB publishes its next set of forecasts – particularly as there is a high risk the inflation trend will continue to be down and diverging even further away from the 2% inflation target.

The market will now return to watching each inflation print. Having said this, the barriers to additional easing appears pretty high at the moment with the ECB keen to give sufficient time for measures to work. If further action was to occur, this would likely be a combination of additional depo rate cuts and QE (which is a change from the previous reliance on QE).

Equally if we see a stronger than expected rebound in growth or inflation in 2016, we may see calls for QE to end earlier (just as occurred in mid 2015). Given that this is remains an extremely weak recovery, significant output gap weak global inflation pressures, we would seek to fade any such expectations.

And Finally  . . .

The theme of continued divergence between the ECB and the Fed will continue to remain strong, with Eurozone inflation prints, market based measured of inflation expectations, Fed actions and EURUSD set to be important data points for European markets in coming months.

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