Euro Macro: Labour market slack will keep underlying inflationary pressures subdued – In announcing a wind down of its asset purchase programme, the ECB expressed growing confidence that inflation would reach its inflation goal over the medium term. The Governing Council concluded that ‘progress towards a sustained adjustment in inflation has been substantial so far’. It added that ‘domestic cost pressures are strengthening amid high levels of capacity utilisation, tightening labour markets and rising wages’. Is the ECB right to be confident? We are sceptical. Core inflation is yet to show signs of an upward trend. Wage growth – the key driver of sustained rises in core inflation over the medium term – has admittedly firmed over the last couple of quarters. However, the improvement is modest and most likely related to higher average headline inflation over the last year or so compared to the past (which is an input into pay settlements) rather than a tight labour market. Indeed, we still think there is slack in the labour market. The U6 unemployment rate in the eurozone, at 17.4% in the latest reading in 2017Q4, was still well above the low of the last cycle of 15%. It is falling by around 1 percentage point per annum (while the pace of the fall in the traditional measure of the unemployment rate has recently actually been slower). That means it will take a considerable time for the labour market to become tight on this basis. In addition, there are lags between a tighter labour market, higher wage growth and rising core inflation. Given this, we judge that core inflation is likely to once again undershoot the ECB’s projections. (Nick Kounis)
Euro Money Markets: Only one obvious replacement candidate for EONIA – The ECB working group (consisting of the ECB, BFSM, ESMA and the European Commission) on euro risk-free rates has launched their first public consultation phase for their proposals of an EONIA alternative. This overnight benchmark ‘can serve as a basis for an alternative to current benchmarks used in a variety of financial instruments and contracts in the euro area’. The likely candidates for the new euro risk-free rate have been mentioned to be the following three:
* Euro Short-Term Rate – ESTER: a wholesale unsecured overnight bank borrowing rate;
* GC Pooling Deferred: a one-day secured, centrally cleared, general collateral repo rate;
* ‘RepoFunds’ Rate: a one-day secured, centrally cleared, combined general and specific collateral repo rate.
The ECB will evaluate all the responses and a summary will be published on 13 September 2018. Based on the summary and details provided by the working group, the most obvious candidate for the new unsecured overnight rate would be ESTER. Particularly due to its relatively high average daily transaction volume, relatively high number of reporting agents or trading partners and a relatively high average number of banks that report daily transaction volumes. Furthermore, ESTER is expected to be more stable during reporting periods as compared to GC Pooling Deferred and the RepoFunds rate. The latter two are heavily dependent on repo data, which are found to be more volatile during quarter end and year end. Regardless of the possibility that during periods of market stress a wholesale unsecured borrowing rate such as ESTER could be less resilient, we expect that the quarter-end and year-end volatility of the repo based alternatives could potentially be a more severe issue for market participants. (Fouad Mehadi)