It seems very likely that the ECB will announce new action at Thursday’s meeting, or at the very least signal that such an announcement is just a matter of time. The big question is what the ECB will actually do. We think that a small asset purchase programme is the most likely option. This could be made up of purchases of asset backed securities in particular. However other types of securities, such as debt issued by supranational European institutions and corporate bond purchases could also be added.
Crucial to their success is that households, companies and investors believe that the central bank is willing and able to keep inflation roughly in line with its inflation goal in the years to come.
Nick Kounis Head of Macro Research
It’s a question of credibility…
Following ECB President Mario Draghi’s comments at Jackson Hole, additional monetary stimulus from the ECB looks very likely. Credibility is the holy grail for central bankers. Crucial to their success is that households, companies and investors believe that the central bank is willing and able to keep inflation roughly in line with its inflation goal in the years to come. If people start expecting them to miss their goal, this starts to be reflected in their price and wage setting behaviour, and it becomes a self-fulfilling prophesy. Following each and every meeting, Mr. Draghi and his predecessors have announced that inflation expectations were ‘firmly anchored’, which essentially means ‘what we are doing is still credible…no reason to panic’. At Jackson Hole, Mr. Draghi made a significant shift, admitting that ‘over the month of August financial markets have indicated that inflation expectations exhibited significant declines at all horizons’. A rough translation is ‘we are losing our credibility…we need to do something!’ Indeed, maybe this was as much a call to arms of his fellow Governing Council members as the global policymakers and academics gathered in Kansas.
Action is very likely…but what?
So it seems very likely that the ECB will announce new action at Thursday’s meeting, or at the very least signal that such an announcement is just a matter of time. The big question is what the ECB will actually do. In our new Euro Rates Weekly, we look at a number of possible scenarios. We think that a small asset purchase programme is the most likely option. This could be made up of purchases of asset backed securities (ABS) in particular. However other types of securities, such as debt issued by supranational European institutions (such as the bail-out funds and the EU) and corporate bond purchases could also be added to give the programme a bit more scale. The ECB has often emphasised that the eurozone’s bank – rather than market – based economy should be taken into account in designing monetary stimulus policies. In this sense, an ABS purchase programme hits the spot. To the extent that a revival of the ABS market could provide banks with a new option for funding and potentially help them to remove some assets from their balance sheets, it could give banks more space to lend. The main disadvantage of an ABS programme is its scale. A scheme focused solely on ABS would total around EUR 50 – 100bn. Even if the other assets are added, it is unlikely to be much bigger than EUR 200bn because these markets are relatively small.
For real scale, central government bond purchases need to be included, because at almost EUR 7 trillion, it is the only market that is liquid enough to allow for a large programme and hence ‘real QE’. For instance, using the Fed’s second QE programme as a benchmark, a sizeable programme for the eurozone should be in the region of EUR 400bn to begin with. The ECB could make up this total by buying government bonds as well as ABS and some other assets. Although we are not as gloomy as some on the eurozone economic outlook, the low levels of inflation do leave the region vulnerable to deflation in the case of a new economic shock. To manage these risks, it would be a good idea to put in place significant monetary stimulus. Indeed, as we have argued previously, this would have been an even better idea some time ago. However, we have doubts about whether the ECB will buy government bonds at the current juncture. Although buying government bonds in the secondary market is perfectly legal, some Governing Council members have been reluctant in the past. In addition, the ECB may well argue that the combination of a small asset purchase programme together with the TLTROs (which it argues could be as large as a trillion euros) could give its monetary policy the necessary bite. Overall then, we think a small programme is most likely in the near term, but the chances of QE have certainly increased.
Even Super Mario is not omnipotent
The danger is that the ECB is being asked to shoulder the economic and financial hopes of the whole region, with other policymakers not doing their share of the heavy lifting. Super Mario has had to save the euro, sort out the banking system and now single-handedly try to foster a stronger economic recovery. As argued above, the eurozone could benefit from yet looser monetary policy, not least to get the euro to depreciate more significantly against other currencies. That will help to lift exports as well as inflation, which is the central bank’s main responsibility. However, monetary stimulus is not the source of long term prosperity. Structural reforms are crucial in the long term. It would be great to see a Super François or a Super Matteo flying to the rescue over the coming months, with some ground-breaking economic policies. But let’s not get too carried away.
Even lower rates, and a weaker euro
Government bond yields have slumped to a succession of record lows over recent weeks. This reflects worries about the economic outlook, falling expectations for inflation and expectations of further monetary policy easing. As explained below, we do expect a moderate recovery to resume over the coming months, while inflation should creep up slowly next year. However the ECB is likely to take further action, and the chances that it will do more will remain high for a time. Against this background, we have significantly revised down our forecasts for government bond yields. We now expect German Bund yields to roughly move sideways at these levels over the next six months. Our 3-month forecast has been reduced to 1% from 1.3% previously, while in the very near term, continued rates below 1% look likely. Later next year, we expect a modest rise in yields as the economic recovery has a somewhat firmer footing. In addition, bond yields tend to move down on expectations of stimulus, but often move higher once the policy is actually in place. We have made more modest adjustments to our EUR/USD forecasts in the same vain. We see the currency at 1.28 at year-end (previously 1.30). Our forecast for the end of next year remains unchanged at 1.20.
Strong US data
Turning to recent economic data, most reports underlined familiar themes. For instance, US economic data were generally strong. GDP growth in the second quarter was revised up to 4.2% from 4%. In addition, the quality of growth was better, as more of it came from business investment and less of it from volatile inventories than earlier estimated. Most reports also suggest that the economy has since sustained above-trend growth rates. For instance, consumer confidence rose to an almost seven year high in August. Durable goods orders saw their biggest gain on record in July. Although this was largely down to volatile aircraft orders, the data were positive underlying terms as well. For instance, core capital goods orders rose by 1.5% after a 0.9% increase in June, signaling robust capital spending by companies. Housing data were a bit more mixed, but remained consistent with a gradual recovery. Housing demand is being supported by an improving labour market and low mortgage rates.
Soft eurozone numbers
Unfortunately another familiar theme was weakness in the eurozone data. The European Commission’s sentiment indicator fell by more than expected in August. It has been on a gradual downward trend over the last few months, however the level is decent from a historical perspective, as it is above the long-run average of the series. Indeed, it remains consistent with moderate economic growth. The country breakdown revealed particular weakness in Italy and France, which has also been a feature of recent data and emphasised that these large eurozone economies are in particular need supply-side reforms. We remain of the view that the eurozone economy will return to growth in the second half of the year following the stagnation in the second quarter. Although our eurozone GDP forecast this year was recently revised down (to 0.9% from 1.3%) that reflected the weak second quarter. A stronger global economy, weaker euro, easier bank lending conditions, ECB stimulus and lower food and energy prices are factors pointing to moderate recovery.
Further fall in eurozone inflation, but higher core
The declines in food and energy prices were visible in eurozone inflation in August. Due to a fall in energy prices in particular, headline inflation fell to 0.3% yoy from 0.4%. The core measure of inflation, which is a better indicator of underlying trends, rose to 0.9% yoy from 0.8% yoy, and it has been on a sideways trend over recent months. This is of course still nowhere near the ECB’s price stability goal, but it does provide some reassurance that we are set for ‘lowflation’ in coming years rather than deflation.