The first working week of the year was spectacular with market sentiment deteriorating sharply. This week has been no less eventful. Investor risk appetite has continued to deteriorate, with worries about global growth and liquidity fuelled by sharply lower oil prices. In the coming week, the ECB is thrown in to the mix with its first meeting of this year. We think the chances of further monetary easing have risen further, and we expect the ECB to deliver before long.
The ECB will likely need to make a sharp downward revision to its 2016 forecast for inflation
Nick Kounis Head of Macro Research
- The ECB meets next week against the background of a further deterioration of the inflation outlook
- Further monetary easing is already justified now in our view, but the ECB may signal that it will consider steps at its next meeting
- Our base case is that the ECB will announce additional monetary stimulus in March, including a further cut in the deposit rate
- We have revised our eurozone GDP growth forecasts lower
The inflation problem is getting worse
The conventional wisdom has been that central banks should look through oil-price driven movements in inflation. We think this is wrong in this case. One reason is the starting point. Inflation has been below the ECB’s price stability goal (of close to 2%) for the last 35 months. It has been less than 1% for the last 27 months. In December the ECB projected that inflation would likely continue to miss its goal in both 2016 and 2017. There is a risk that the world at large stops believing that the ECB will deliver on its target.
A self-fulfilling prophesy
If people stop believing in close to 2% inflation, then very low inflation could become entrenched. For instance, employers and employees may assume much lower inflation when setting prices and agreeing wages. There are signs that inflation expectations have indeed come down significantly over the last few months (see chart above). In addition, nominal wages have remained rather weak despite falling unemployment. There is a possibility that wages are just lagging, but it seems to fit with other evidence.
Inflation set to fall back into negative territory
Since the December ECB meeting the inflation outlook has deteriorated. Inflation is likely to dip back into negative territory over the next few months. This partly reflects the ongoing sharp fall in oil prices, with Brent falling through the USD 30 per barrel level. Our base case is for a gradual recovery during the course of the year, but this would still see the drag from oil prices on annual inflation intensifying in the coming months.
Core inflation also set to soften
The idea that ‘only’ energy prices are depressing inflation might be considered some sort of comfort. However, this is not really applicable in this case. Core inflation stood at 0.9% yoy in December, at less than half the ECB’s price stability goal. In addition, had it not been for the fall in oil prices, eurozone domestic demand and hence underlying inflationary pressures may have been weaker still. Rather than strengthening, core inflation may also soften in the near term. Lower oil prices are having second round effects on items in the CPI that have a strong link with energy. As noted above, there are also signs that low inflation is helping to restrain wage growth. Furthermore, the upward impact of past falls in the euro are starting to fade. Meanwhile, there are some signs that the eurozone recovery lost some momentum in the second half of last year.
Recent eurozone hard data have been disappointing
For instance, eurozone industrial production contracted by 0.7% mom in November. Although that followed a 0.8% gain in October, that still left production more or less flat up to that point in Q4. Recently retail sales have also disappointed and our GDP tracker is currently pointing to stagnating GDP at the end of last year. Exports have also weakened. This points to a slowdown in GDP in Q4 following a 0.3% gain in Q3. We do think that the recovery will continue during the course of this year. Surveys of the eurozone economy and unemployment numbers have been upbeat. However, overall growth will likely be more moderate than previously expected. We have revised our eurozone GDP forecast down to 1.6% this year (from 1.9% previously) and 1.9% next year (from 2.2%).
ECB set to step up monetary stimulus
The ECB will likely need to make a sharp downward revision to its 2016 forecast for inflation, while its 2017 projection will likely also once again need to come down to even further below 2%. We think there is a strong case for the ECB to act already at next week’s meeting and the chances of a move are rather higher than suggested by the overwhelming consensus for no change. Nevertheless, on balance we think the ECB will likely stay on hold for now. The Governing Council has not been able to react decisively to events over recent months due to splits in opinion about whether action is necessary and/or what policy measures to take. So it seems likely that the ECB will need more time to assess.
Signal in January, action in March
We think ECB President Mario Draghi will step up the dovish rhetoric at next week’s meeting and hint that further action may follow before long. Our base case is that the ECB will announce additional monetary stimulus in March. The key measure will likely be a further 10bp reduction in the deposit rate, though it may also couple this with a moderate enhancement of the QE programme.
Not out of bullets yet
Looking further forward, we do not think the ECB has run out of space to ease policy further. We think central banks in Scandinavia, such as Sweden’s Riksbank have shown that the deposit rate can come down further. The room to sharply step up QE under the current design is limited, given the use of the capital key to allocate purchases between countries and the size of the markets for debt securities in particular countries. There are potential strains especially for German securities under this system. However, if the ECB really needs to go further it could change the modalities of the programme to give it more room to step up QE. For instance, if a more adverse scenario developed, it could drop the capital key and allocate purchases on the basis of outstanding debt securities.