ECB President Mario Draghi disappointed market participants. This says more about how hyped up market expectations were than about what is urgently needed. One thing is clear, the ECB will step up its actions in the new year. Two points are important to make about this. First, it really isn’t all that relevant how the ECB achieves its aim of lengthening its balance sheet, as long as it achieves it. Second, the ECB has very little chance of raising inflation expectations in the short term. Oil prices are currently driving inflation expectations and the ECB does not play a role in the oil market. Meanwhile, various indicators signal that the weakness of the German economy over the summer and the autumn will prove to be temporary.
Ever since his speech at Jackson Hole in August, ECB President Mario Draghi has raised expectations that the ECB would shortly and aggressively step up its actions. Indeed, the ECB has been buying covered bonds and they have been more aggressive than they had on previous occasions. Deteriorating economic conditions and uncomfortably low inflation are good reasons for the ECB to try to boost the economy and try to push inflation back to its target of ‘below, but close to 2%’. Participants in financial markets were, apparently, hoping that Draghi would announce further steps at the press conference yesterday. He did not. Instead, he indicated that such action will come after the turn of the year. Markets were disappointed. Perhaps it was not only the timing of the action that fell short of expectations, but also the specifics of what Draghi said. Market participants may have assumed that so called ‘sovereign QE’ (the ECB buying government bonds) was a done deal. But Draghi did not commit to that. Buying government bonds is controversial. It would be more convenient if the ECB was able to lengthen its balance sheet without purchasing government bonds.
…but more action on the way
We think it is better to look at the broader message. And that message is quite clear. The ECB is determined to lengthen its balance sheet significantly. How it will achieve that is actually not really that relevant and it depends on a number of issues. Most important, the more banks borrow from the ECB under the TLTRO facility, the less chance that the ECB will feel obliged to buy government bonds to achieve the desired increase in its balance sheet. We will get a clearer picture shortly when the second tranche of the TLTRO will be allocated in a few days. In addition, the ECB will first look at other assets, such as agency debt and corporate bonds, before buying government bonds.
Central bankers watch inflation expectations very closely. They like them to be ‘anchored’ near their target. The idea is that inflation expectations affect behaviour and if inflation expectations fall too much and stay too low for too long, the economy is in danger of entering sustained deflation. Inflation expectations in the eurozone have become ‘dislodged’. In the course of 2014, the anchor has started drifting. As such, it is reasonable for the ECB to react to that. But there is a big ‘BUT’. Inflation expectations are driven by oil prices in the short term, particularly when oil prices move significantly. The simple truth is that the ECB has no control over or effect on oil prices. Therefore, the ECB is largely impotent when it comes to affecting inflation expectations in the short term. While we think that oil prices will soon find a bottom and then bounce a little, chances are relatively high that lower energy costs will push eurozone inflation down further and, possibly, into negative territory, at least for a while. This would not be the end of the world.
Falling oil: good or bad?
Mr Draghi talked a lot about oil prices in his recent press conference. The message is not entirely clear, at least, not to me. In the past, the ECB, and the Bundesbank before that, have always played down the relevance for monetary policy of swings in oil prices and their impact on headline inflation. And it is important to determine what causes the decline in oil prices. If lower demand for oil (resulting, for example, from a recession) is the main driver, then slumping oil prices are a symptom of an economic problem. The situation is different if higher oil production is the main cause. We believe that the current decline in oil prices is more caused by the supply side of the oil market than the demand side. That is an important reason for us to see the decline in oil prices mainly as a tailwind for the global economy and for oil importers in particular, obviously. The eurozone economy will benefit and growth is likely to pick up in the months and quarters ahead.
The ECB is too pessimistic on growth
The ECB has lowered its GDP growth and inflation forecasts for 2015 and 2016. The downgrade of its growth forecast for 2015, from 1.6% to 1.0% was particularly large. We think the ECB is now far too pessimistic. It looks to us as though the revision was largely driven by disappointing data over the summer. We have argued that the weakness would be temporary as the economy will increasingly enjoy tailwinds from lower oil prices, lower borrowing costs, the decline in the euro, less austerity and the healing of the credit channel. In addition, we have argued that the weakness over the summer was partly the result of an inventory correction in the industrial sector globally. Such corrections are temporary by definition.
Recent data encouraging
Recent economic data is consistent with our more optimistic view. Eurozone retail sales recovered a little in October from a sharp drop in September. More importantly, German factory orders were strong in October and significantly ahead of expectations, following a couple of months of weakness. The picture emerging from various sectoral confidence indices is also positive. Confidence in the German retail sector and in German construction rose significantly in November, the second consecutive material improvement. The strengthening of confidence is cancelling out weakness in previous months.
The US labour market report delivered its strongest job growth in three years. Underutilisation in the labour market is gradually diminishing. The November nonfarm payrolls report (+321K) showed that employers ramped up hiring. The unemployment rate was unchanged at 5.8% which is below the Fed’s end of year forecast. Both indicators suggest that the economy is making fast progress towards maximum employment. The labour market is now showing tighter conditions which should spur wage growth.
Our views on these issues can be summarised in the following bullet points:
- The ECB will expand its balance sheet more aggressively in the new year
- The market is obsessed with the question of whether or not the ECB will buy government bonds, but that is not so relevant as long as the ECB lengthens its balance sheet.
- The ECB will, if possible, avoid, but certainly delay buying government bonds, because such purchases are controversial. In any event, government bonds will not be at the top of the ECB’s shopping list when the ‘sales’ start after Christmas.
- Should the ECB fail to lengthen its balance sheet without buying government bonds, they will not hesitate (too long) to enter that market.
- The ECB is worried over inflation expectations, but has very little influence over them in the short term.
- Eurozone headline inflation may fall into negative territory in the months ahead. This is not the beginning of a sustained period of painful deflation.
- Recent data suggests that the weakness in the eurozone seen over the summer and the autumn will be temporary
- The slump in oil prices is largely driven by higher oil production and is therefore a significant tailwind for the global economy in 2015, and for the eurozone in particular