Global Daily – ECB to stay cautious for now

by: Nick Kounis , Maritza Cabezas

ECB Preview: Too early for major shift in guidance – The ECB meets on Thursday, with inflation broadly in line with its medium-term goal and surveys pointing to a brightening outlook for the economy. There has been speculation that this should see the Governing Council start preparing an exit from its unconventional monetary policies. Still, we think that the March meeting comes too early to see major changes in communication. Here there are two considerations. First, the macro data is not quite as shinny as it looks. The business surveys have been buoyed by strengthening exports and investment. However, consumer spending is now slowing down on the back of falling real wages. This trend should continue and will likely limit the momentum in overall economic growth. Meanwhile, we think the February data point will probably mark the peak in headline inflation as annual energy inflation will fall back. Core inflation remains steady at 0.9% and needs to start moving up for the ECB to be confident that it will meet its inflation goal in a more sustainable way. However, with nominal wage growth weak, this will take a while. Second, the Governing Council has signalled that very easy financial conditions will be necessary to keep the reflation process on track. However, a too early shift in communication could lead to a premature tightening in financial conditions, so we think the Council will remain cautious for now.

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ECB Outlook: Change in forward guidance in June – We therefore think that the path towards the exit will be a gradual one. Our base scenario of the timeline is set out in the slide attached. We think the first step will be a change in the ECB’s forward guidance at the June Governing Council meeting. Currently, the guidance is asymmetric, with the ECB signalling that it has room to cut the deposit rate or step up QE in the case of negative news. We think the guidance will become more neutral. For instance, on interest rates, the ECB could signal it will keep interest rates at current levels (dropping the phrase ‘or lower’) until well after QE ends. At the same time, the ECB could drop the line ‘if the outlook becomes less favourable, or if financial conditions become inconsistent with further progress towards a sustained adjustment in the path of inflation, we stand ready to increase our asset purchase programme in terms of size and/or duration’ from its forward guidance. We then expect the ECB to set out its plan for tapering in September. It could signal a tapering of asset purchases in 2018, contingent on seeing progress in inflation that would make it more confident in meeting its medium term goal. We expect tapering from April 2018 onwards at a pace of EUR 10bn per month. That would see the programme coming to a halt in September of next year. We expect the first deposit rate hike in March 2019.

Fed view: Futures suggest markets ready for a March rate hike – Chair Yellen delivered a hawkish speech in Chicago on Friday, giving a strong signal that the next rate hike could be in March.  She mentioned that at the “FOMC meeting later this month (14-15 March), the Committee will evaluate whether employment and inflation are continuing to evolve in line with our expectations, in which case a further adjustment of the federal funds rate would likely be appropriate.”  With respect to the process of scaling back accommodation, Chair Yellen mentioned that the pace of rate hikes will remain gradual, indicating that FOMC members expect “the evolution of the economy to warrant further gradual increases in the target range for the federal funds rate”. She added that there is no evidence that the Fed “has fallen behind the curve”.  Meanwhile on Friday, Federal Reserve Governor Jerome Powell, also mentioned that the case for a rate hike increase at the Fed’s March meeting has “come together”. A similar message was delivered earlier last week by New York Fed President William Dudley, typically considered a dove, who noted on Tuesday that the case for a rate increase has become “a lot more compelling”, while John Williams, President of the San Francisco Fed,  said last week that March is “very much on the table for serious consideration”.  Several other FOMC members have signalled that they broadly share this view.  The market implied odds on a March rate hike, as indicated by the federal funds futures,  jumped from about 40% last week to around 94% today. We forecast three rate hikes in 2017, starting in March, followed by June and September. (Maritza Cabezas)