Global Daily – ECB and Fed Previews

by: Nick Kounis , Aline Schuiling , Bill Diviney

ECB Preview: End of net asset purchases, but path of policy rates is key – Following ECB Chief Economist Peter Praet’s speech last week, an announcement to gradually wind down net asset purchases will likely come at this week’s Governing Council meeting. However, there is a possibility that the Governing Council takes a two-step approach, as it has done in the past. For instance, it could signal the wind down in June, with the details (on the tapering period and the purchase sizes) following in July. We expect a tapering period of 6 months (3 months EUR 20bn p/m and 3 months EUR 10bn p/m), meaning that net asset purchases will not end until March 2019. The tapering period could well be shorter though (3 months).

Forward guidance on rates to be dovish – There will understandably be a lot of focus on the end of net asset purchases. However, we do not think the details matter that much at this stage. The stock of asset purchases is already large enough to have an ongoing depressing impact on bond yields (please see our note here). What will move bond yields going forward will be the timing and path of interest rate increases. We therefore think that the ECB’s forward guidance on interest rates will be crucial. The ECB has signalled that it will strengthen the guidance and make it more concrete. Despite the ECB’s recent bravado, we think that weak underlying inflationary pressures and uncertainty about the growth outlook mean rate hikes are further away than financial markets are currently pricing. We would therefore expect the ECB ‘s message on interest rates to be dovish.

How could the ECB change its guidance? One possibility is to be specific about the time period over which interest rates will remain on hold. For instance, it could say interest rates will remain on hold until at least X month of next year. In addition, the ECB could give a nudge that when interest rate do rise, it will be in steps of 10bp rather than larger moves. It could for instance use language such as ‘gradual pace’ and/or ‘measured steps’. We do not expect the first rate hike until September 2019, while the recent weakness in economic data and weak core inflation raises the risk that rate hikes will come even later than in our base case (see below).

ECB will probably lower its forecast for GDP growth and raise that for headline inflation – The ECB will publish its new staff macroeconomic projections for the euro area on Thursday as well. When making these projections the ECB uses technical assumptions about interest rates, exchange rates and commodity prices. When looking at the changes in these variables between the ECB’s March projections and the cut-off date for the June projections (usually some two-and-a-half weeks before the publication date) it appears that the trade weighted exchange rate of the euro has depreciated by around 2.5%, while oil prices have risen by around USD12 per barrel. The levels of interest rates (short-term as well as long-term) have remained almost unchanged. The changes in the exchange rate and oil prices probably would have roughly the same impact on GDP growth, but with opposite signs. Their impact on inflation, however, would be that they each have an upward impact on headline inflation, albeit temporarily. Besides the changes in financial variables, the ECB’s forecasts will also be influenced by the economic data that has come in since the ECB’s March projections. Most importantly, GDP growth in Q1 disappointed, falling to 0.4% qoq, down from 0.7% in Q4. Moreover, sentiment indicators and hard economic numbers that have been published so far for March and April do not signal that growth accelerated sharply moving into Q2, with the industrial sector showing signs of weakness in particular. This means that the central bank could revise its projections for GDP growth in 2018 slightly lower, from its current forecast of 2.4%. With regard to inflation, the weaker euro and higher oil prices will probably lift the ECB’s forecast for headline inflation in 2018 by around 0.2 percentage points (up from 1.4% now). Its forecast for headline inflation in 2019 and 2020 (of 1.4 and 1.7% respectively) as well as its forecasts for core inflation (1.5% in 2019 and 1.8% in 2020) will probably remain roughly unchanged. (Nick Kounis & Aline Schuiling)​

Fed Preview: A shift in the ‘dots’ is likely, but not yet – The FOMC will almost certainly raise its target range for the fed funds rate by 25bp this Wednesday, taking the upper bound to 2.00%. The focus for markets will be on: 1) the quarterly Summary of Economic Projections (SEP), and 2) Fed Chair Powell’s press conference. For the SEP, unlike last time, we do not expect significant changes to the ‘dots’ projections for further rate hikes this year and next. The macro outlook has not changed significantly since March, and neither has the composition of the FOMC. With that said, given that it was on the borderline in March between a 3- and 4-hike projection for 2018, we think it is a matter of time – or more specifically, Senate approvals – before the dots shift to expecting four rate hikes this year. Both John Clarida and Marvin Goodfriend – who would be voting members this year if approved by the Senate – are likely to be in the ‘four hikes’ camp, in our view (the other nominee, Michelle Bowman, is as yet an unknown quantity). For Chair Powell, a focus in the press conference will no doubt be on risks to the outlook from trade tensions, but beyond acknowledging that risk, he is unlikely to express grave concerns, given the political sensitivity of the topic. Another issue that could crop up is dollar liquidity concerns, coming on the back of recent stress in some emerging markets. We believe Chair Powell will seek to downplay the Fed’s role in such stress, consistent with his speech in early May (see also here).

Beyond this, we expect a one-off change to the spread between the IOER (interest on excess reserves) rate and the fed funds rate, as signalled in the May FOMC minutes. The IOER has up until now been moved in line with the upper bound of the target for the fed funds rate, but the Fed had expressed concern that this was causing the effective fed funds rate to move too close to the upper bound of the target range, as it has in recent months. An adjustment lower, likely by 5bp (so the IOER would be raised by 20bp rather than 25bp), would help keep the fed funds rate more comfortably within the target range. Given that this is a well-flagged technical adjustment, however, the market impact of this should be limited. (Bill Diviney)