This week could see a momentous signal from the ECB
4th September 2017
The European Central Bank’s (ECB) meeting on September 7th will be the next chance for the Governing Council (GC) to communicate its intentions as regards the outlook for the Asset Purchase Program (APP).
As Mr. Draghi refrained from giving any hint in his Jackson Hole speech, which focused only on global growth, market attention will be extremely high. It is also possible that the GC will refrain from communicating any definitive decision and will wait until the October meeting, but the publication of the quarterly growth and inflation forecasts make the September meeting an interesting one anyway.
What are market expectations as regards Quantitative Easing (QE)? As the amount of bonds that can be purchased in the Asset Purchase Program shrinks over time and purchases are completed, it is consensus that the amount of QE will have to be reduced in 2018, because the 33% maximum buying limit in each bond will start to bite. How much will the reduction be? A range of hypotheses have been floated; a median view points to 6 to 9 months of additional buying, at a rate of some 40bn Euros at the beginning of 2018, to be reduced to 20bn Euros after a few months. In late 2018 or early 2019, a small hike in the Deposit Rate would follow; an increase of just 4 basis points (from -40bp) is discounted for the September 2018 meeting.
How could the ECB change market perspective?
Arguments surely exist to support a more hawkish stance: growth forecasts for the Euro Area (EA) have steadily improved in recent quarters, core inflation is finally moving up, and headline inflation is still impacted by base effects in energy prices, but is way above the negative prints of 2015. The unemployment rate is in a downward trend and should reach the “non-accelerating inflation” level (NAIRU) sometime next year. On top of this, fiscal policies in the EA are more accommodating than in previous years and financial conditions have improved. Then, why not send the message that “the time for extraordinary measures is almost over, get ready for (much) less accommodative policies next year”?
Not so fast: an alternative route is also possible. Mr. Draghi may still point to the lack of sustained pick-up in inflation forecast and inflation expectations (the 5yr-5yr forward inflation swap is still below 2%, as in 2014…) as a sign that further stimulus is needed.
Higher employment has, so far, failed to push up wages, a precondition for a sustained pickup in core inflation. Then, the ECB would have to consider all the negative consequences of a hawkish stance; stronger euro, wider spreads in peripherals and credit, just when Italy is facing a key political election sometime between February and May next year. Why not send a reassuring message, like “yes, we will withdraw some stimulus, but very slowly, and we are ready to add more if things deteriorated a bit”?
As both sides have some merits, both are possible; however, what is missing is a key ingredient that may push the balance in favor of a hawkish or dovish stance; the ECB judgement of how large the pool of remaining purchasable bonds is. Several estimates circulate about how many bonds the ECB still has room to buy in 2018. These estimates take different assumptions for potential adjustments to the purchasable universe, and on the “flexibility” allowed to deviate from the capital key rule. But ultimately, nobody really knows what the ECB sees as its limit.
Should the ECB judge that the amount of bonds still in its purchasing universe to be “large”, it may use the downward revision to 2018/2019 inflation due to the stronger euro as the rationale for favoring the “dovish” arguments (i.e. the APP needs to run further, maybe until the end of 2018, as inflation is still too low).
On the other hand, if the ECB is worried that the bond universe is “small”, something that will force it to taper anyway, it could start stressing that the growth outlook has brightened a lot and that the slowing down in inflation is “temporary” (i.e., the APP has worked, mission is accomplished, inflation will rise later, QE may be over in the first half of 2018).
Which side will be taken on September 7th? Maybe none of them in a clear way… but if the ECB focuses more on inflation with respect to growth, or vice versa, we may get a hint of where they think the limit in QE is, and how much spare buying power is left.