- Sharp fall in inflation has made ECB action likely, but not at today’s meeting…
- … with the Council likely to wait for the December 2014015 inflation projections
- China’s leaders will discuss the direction of economic reforms at this weekend’s third plenum
ECB will likely keep the refi rate on hold today, but action in December likely
Since the sharp fall in inflation last week, speculation that the ECB will cut interest rates has intensified. The Euro rebounded overnight as this does not seem likely at today’s meeting. Several Governing Council members – most notably the Austrian and German central bank heads – have reservations and therefore ECB President Mario Draghi may need more time and evidence to steer the Council in this direction. October’s inflation number was a flash estimate so more details would probably be welcome, while at the December meeting the ECB will publish new forecasts for economic growth and inflation, which will extend to 2015 for the first time. Nevertheless, we do think that action is likely at the December meeting. We think that the central bank’s new projections will show inflation significantly undershooting its price stability goal over the next two years, which includes the so-called ‘policy-relevant horizon’. This reflects that the economy is recovering, but only slowly following a long period of weakness when substantial economic slack has built up. Although deflation is not our central view, at low rates of inflation, the risk of such an outcome in case of a negative demand shock rises. As such, we expect the ECB to cut its refi rate by 25bp next month to 0.25%. In addition, we expect it to strengthen its forward guidance to signal that it expects – given its current scenario – short-term interest rates to remain on hold for longer than currently priced in by financial markets.
China’s road map to reforms
Looking further forward, China’s four-day third plenum starts on Saturday, during which its leaders will define the direction of economic reforms, which will influence the longer term economic outlook. This third plenum is the first after the leadership transition. The outcome of past plenums suggests that a road map will be presented. In this case, it will be broadly in line with the 12th Five-Year plan, which already has an ambitious agenda centred on gradually directing the economy towards domestic consumption. We expect a broad outline focusing on financial reforms and reforms tackling the new responsibilities of local governments. Meanwhile, other reforms – such as land reform, urbanisation and restructuring of state-owned enterprises – will likely be announced but we do not believe their implementation will start until after 2014. Other reforms, which include reducing red tape, will rightly remain a priority. The current leaders have been quite successful in balancing accountability with further solidifying their power base.
Reforms, however, are not just about content but also about timing. If the reforms are implemented upfront, potentially implying, for instance, more monetary tightening while reducing mounting debt, this could mean somewhat slower growth than we are forecasting for the coming years. In general, policy uncertainty surrounding more complex reforms has proven to be negative for investment and growth. If, as we expect, measures are implemented in a more gradual way and the authorities manage to convince markets that long-term sustained growth remains a priority, we believe this will have a positive impact on GDP growth. This will mainly be the result of improved confidence, at least in the coming year. Our forecast for GDP growth in 2014 is 8%. However, as reforms filter through to the economy, growth could slow somewhat beyond 2014 to around 7%. Still, the quality of growth should improve. Finally, the consequences of delaying reforms indefinitely are significant. This could result in unwelcome excesses in the property market, an even larger number of non-performing loans and manufacturing overcapacity. While we consider this scenario unlikely, it would significantly increase the risks of a sharp slowdown and even a hard landing.