Global Daily – ECB preview: Silence is not golden

by: Nick Kounis , Aline Schuiling

The ECB’s Governing Council meets on Thursday to discuss monetary policy. Financial markets will focus on three interrelated issues: (1) The ECB’s new growth and inflation forecasts (2) Guidance on the future path of QE and interest rates (3) The Governing Council’s views degree of comfort on the euro appreciation. We cover these issues in turn.

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The new growth and inflation forecasts

There have been two major developments since the ECB’s last meeting. On the one hand, economic growth has been stronger than its economists anticipated. On the other, the euro has strengthened materially. We think on balance these changes will broadly cancel each other out, leading in only a slight downgrade to the ECB’s 2019 inflation forecast (to 1.5% from 1.6%). For more on this issue, please see our note here. The ECB could well also extend its forecasting horizon to 2020 (even though this would not be normally due until December). Showing inflation close to its goal in 2020 (at around 1.8%) could help it to explain its exit strategy.

Guidance on QE and interest rates

We think that the ECB will set out a detailed plan to taper its asset purchases in October. However, we expect it to give guidance of the direction of travel at Thursday’s press conference. For instance, it could alter its forward guidance on QE, to omit the suggestion that it would increase the pace of asset purchases, while maintaining that it could extend their duration. ECB President Draghi could also signal that the central bank would alter the pace of asset purchases after December, though it would be a gradual process. In addition, he may communicate that the details will follow at the next meeting. Finally, the ECB will likely stick to the forward guidance on interest rates, that they will remain at current levels until well after asset purchases end.

Degree of comfort on euro strength

The ECB does not seem to be too concerned with the rise in the euro to date, which is also reflected in the modest changes we expect in its growth and inflation forecasts. However, the central bank will not want the move to go significantly further as it will start to have a more material effect on its already low inflation outlook. Indeed, in its last meeting, the account noted that ‘concerns were expressed about a possible overshooting in the repricing by financial markets, notably the foreign exchange markets, in the future’. Therefore, we think that the ECB will tailor its communication and exit strategy in a way that limits further euro strength. It may choose to more explicitly mention further euro strength as a downside risk as it would tighten financial conditions. In addition, it could announce that tapering will be relatively slow and that rate hikes are a long way off.

The most effective approach for the ECB to curtail euro strength would be for it to cut the depo rate further. Given the ECB’s concerns about the impact of negative interest rates on the banking sector, this is not a serious option. The next most effective tool would be to extend asset purchases through 2018, rather than tapering them. However, we do not think this is an option, as the ECB’s government bond holdings of many member states would reach very close to the issue(r) limit in the first half of 2018 in such a scenario. That would leave the ECB’s purchases focused mainly on just 3-4 countries, which would probably be politically unacceptable. In addition, the pricing in of ECB rate hikes for 2018-2019 is relatively modest, suggesting there is not too much room to push down the euro by steering market interest rate expectations lower. So although the ECB can dampen the euro via its communication, it would have limited tools to turn the tide in the case of – for instance – a more significant bout of dollar or sterling weakness.

Silence is not golden

Of course the ECB could chose to leave its forward guidance unchanged, give no signal whatsoever about changes to the QE programme beyond 2017 and stay silent on the euro. Indeed, a recent story on Bloomberg (quoting unnamed ECB officials) suggested that the complete details of the exit strategy might not be announced until December. We think that such a late announcement and silence in the meantime would be a mistake. It could give a green light for the euro to climb higher and the ECB would not manage to clearly shape market expectations about the exit. It could cause uncertainty and financial conditions could tighten. Therefore we think early communication about a slow exit would be better.