What happened Mario?

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They were waiting for fireworks but ended up with sparklers’, was one comment after Thursday’s ECB meeting. Another was that ‘ Draghi overpromised and under delivered’…ouch.

The other ‘big beast’ of central banking, Fed Chair Janet Yellen, struck a positive tone on the US economy, adding to signals that the central bank would raise interest rates later this month Nick Kounis Nick Kounis Head of Macro Research

  • The ECB’s modest package of easing led to a sharp sell-off in equity and fixed income markets as well as a sharp rise in the euro
  • With inflation on track to undershoot the ECB’s goal, we think risks are skewed towards a new round of stimulus
  • Strong US job data and Yellen commentary suggest December rate hike is on – but pace of cycle will be slow

Indeed, although the ECB did announce further easing, the measures fell short of market expectations as well as our own (for a more detailed analysis of the measures see here).

The 10bp reduction in the deposit rates taking it to -0.3% was less than what was priced in by financial markets. At the same time, the ECB decided to leave the size of monthly asset purchases unchanged, whereas markets expected an increase.

The decision to increase the duration of the programme to ‘March 2017 or beyond’ was underwhelming because September 2016 was always considered a soft deadline anyway. Finally, the announcement that proceeds for maturing bonds would be reinvested has been the standard practice in the QE programmes of other central banks so hardly new information.

Markets disappointed

After the ECB announced policy easing, eurozone equity markets plummeted, government bond yields jumped and the euro surged. It is difficult to believe that this was what ECB President Draghi had in mind when he woke up on Thursday morning.

The disconnect between market expectations and what the ECB eventually delivered raises questions about what ‘went wrong’. There are press reports that the hawks got the upper hand, but Vice President Constancio has since clarified that this was the package that the Executive Board had proposed and that markets just misread the ECB. The ECB judges that the measures are enough and that it can always do more if the situation changes.

Under-shooting inflation

Whatever the rights and wrongs of the ECB’s communication and how the markets interpreted it, the bigger issue is whether yesterday’s measures will get inflation back close to 2% over the medium term. Here we have our doubts. The ECB revised down its forecast for inflation in 2017 to 1.6% from 1.7%.

Graph: ECB forecasts for inflation

The ECB seems to be relying on easing financial conditions due to its measures to close the gap, but yesterday’s market reaction – that resulted in tighter financial conditions - casts doubt on that. Following the bounce, EUR/USD is now in line with the 1.09 level that the inflation forecast was based on. In addition, the oil price is currently around USD 10 lower than it assumed in the projections, which points to lower inflation.

Risks skewed towards another round of easing

Given that the ECB is forecasting an undershoot of its inflation target and financial conditions have tightened, the risks are skewed towards a new round of monetary stimulus in the coming months. The impact of Fed rate hike expectations on EUR/USD, the evolution of oil prices and developments in the hard activity data in the eurozone will be crucial factors. The ECB’s next forecast update in March 2016, could be the moment of truth.

Yellen optimistic on the economy

The other ‘big beast’ of central banking, Fed Chair Janet Yellen, struck a positive tone on the US economy, adding to signals that the central bank would raise interest rates later this month. Speaking to the Economic Club of Washington she said that recent data had been consistent with ‘continued improvement in the labour market’ that ‘helps strengthen confidence that inflation will move back to our 2 per cent objective over the medium term’.

Risks of waiting too long

She also underlined the risks of waiting too long before raising interest rates, saying ‘were the FOMC to delay the start of policy normalization for too long, we would likely end up having to tighten policy relatively abruptly to keep the economy from significantly overshooting both of our goals’.

Lower peak, gradual pace

In separate remarks to Congress, Chair Yellen also gave some insights into the future pace of monetary tightening. She stressed that this would be ‘gradual’. One of the reasons she gave was the strength of the dollar. In addition, the neutral or long-term rate had fallen sharply and remained ‘quite depressed’. This means that the peak in interest rates would also likely be much lower than in the past.

Strong US labour market data make December hike a done deal

UThe data coming out of the US economy over the last few days by and large provided strong support to Chair Yellen’s upbeat message. The labour market data in particular were very impressive. Nonfarm payrolls rose by 211K in November, which represents a very strong outcome following the buoyant 298K reading in October. There was an upward revision to the previous two months of 35K. The labour force participation rate also rose (to 62.5% from 62.4%), while the unemployment rate held on to last month’s decline, remaining steady at 5%. Finally there were signs that wage growth is firming, with a 0.2% mom gain in earnings following the 0.4% rise the previous month. This report makes a December rate hike look like a done deal.

Graph: US labour market going strong


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