Global Daily – How would the ECB react to a longer soft patch?

by: Nick Kounis , Bill Diviney

ECB View: Further rate hike delay if more sustained slowdown is confirmed – Today’s flash PMI data for the eurozone for May open up the possibility that the eurozone economy had slowed to trend rates for a more sustained period (see below). Our view is that growth will soon resume an above-trend trajectory, but downside risks have increased. This raises the question of how the ECB would react if economic growth does get stuck at trend rates for longer than we (or the central bank itself) think. Given it takes above trend GDP growth for the labour market to continue to tighten and for underlying inflationary pressures to build, a sustained slowdown to trend growth rates would mean monetary policy would need to remain very accommodative for longer.

That much is perhaps obvious, but how would it calibrate its various tools? Ostensibly, a wind down of net asset purchases is dependent on underlying inflationary pressures building, so on the surface a further extension of net asset purchases would make sense. However, the ECB seems heavily invested in the idea of winding down the programme. One reason for this is its view that the stock of asset purchases has a bigger impact than the flow. Furthermore, that the stock is already large enough to keep bond yields relatively low (and hence financial conditions easy) whatever happens to net asset purchases. The ECB could decide on a much longer taper period, but we doubt it would react by announcing a further open-ended extension of QE. Indeed, the ECB’s more significant reaction would be to delay the timing of the first rate hike even further.

The market reaction seems consistent with this view. Following today’s weak PMI data, expectations of future short-term interest rates declined. However, in our view, rate hike expectations remain too high. A full rate hike looks to be still priced in by the middle of next year. Even in our constructive base scenario for growth, we do not expect a rate hike until September 2019. If growth turns out to be weaker – getting stuck at trend rates rather than recovering – rate hikes would likely be delayed even longer. (Nick Kounis)

Euro Macro: PMIs consistent with trend economic growth – The eurozone composite PMI fell to 54.1 in May from 55.1 in April. At current levels, it is consistent with GDP growth in Q2 of around 0.4% qoq (in line with the actual outcome for Q1), which is consistent with trend growth rates. Our base case is that economic growth will recover to above-trend growth rates in coming quarters. We stick to that view. The weaker growth over recent months seems to be partly due to transitory special factors (less working days for instance) as well as a slowdown in export growth to Asia. We see signs that the latter is recovering. However, the PMI figures have dented our conviction in a return to stronger growth rates and downside risks to our economic outlook have increased. (Nick Kounis)

US Macro: Housing once again putting upward pressure on inflation – US new home sales fell -1.5% mom in April, while March numbers were revised lower, having now risen 2.0% mom rather than 4.0% as previously reported. Despite the disappointing outturn, the US housing market remains on a strong footing, supporting construction and in turn economic growth. However, the pace of increase in home ownership remains subdued, and this appears to be putting renewed upward pressure on the shelter component of inflation, due to strong demand for rentals; shelter inflation picked up to 3.4% yoy in April, up from a low of 3.1% in February. Having bottomed at 63.1% in Q2 2016, the home ownership rate is up just 1.1pp to 64.2% as of Q1 this year – well below the pre-crisis high of 69.2%. Indeed, at the current pace, it would take perhaps 10 years for home ownership to recover to pre-crisis levels – making it unlikely this will happen in the current economic cycle. We see a number of structural factors holding back ownership, including considerably higher lending standards of banks following the subprime crisis, and increased student debt levels preventing young people from taking on large mortgages (a subject the NY Fed last week published research on – see here). As such, although we expect home ownership to continue to recover, the cooling effect this has on inflation is likely to be more limited than we had earlier anticipated. (Bill Diviney)