ECB View: Rate guidance is now the key policy tool – The ECB announced the end of one key policy instrument today, but launched a new one. As expected, it signalled an end to net purchases under its QE programme, by the end of the year. On the other hand, it launched time-specific and situation-dependent forward guidance on interest rates, which suggests that its policy rates will remain on hold at least until September 2019. If risks to the outlook rise, the ECB is likely to effectively ease monetary policy by signalling an even longer period before its first rate hike, rather than resuming QE.
The end of QE
The Governing Council said that it ‘anticipates that, after September 2018, subject to incoming data confirming the Governing Council’s medium-term inflation outlook, the monthly pace of the net asset purchases will be reduced to €15 billion until the end of December 2018 and that net purchases will then end’. This decision was well flagged by its Chief Economist Peter Praet last week on the basis that the inflation conditions for the end of net asset purchases had been met. We are unconvinced about whether the inflation criteria have indeed been met. It seems there is more uncertainty now than a few months ago about the economic outlook, and core inflation and wage growth remains subdued. Rather, the ECB was always minded to wind down net asset purchases after September. The constraints for the PSPP are fast approaching, as the Bundesbank’s holdings of German public sector bonds will be at or very close to the issue(r) limit by then. In addition, the ECB believes that the stock effect of purchases is the dominant effect on financial conditions and that the stock is already large enough to ensure this.
Rate guidance strengthened
Crucially, the ECB strengthened its forward guidance on interest rates. It made the guidance more specific in terms of timing, but also conditional on inflation making progress towards its aim. The Governing Council asserted that it ‘expects the key ECB interest rates to remain at their present levels at least through the summer of 2019 and in any case for as long as necessary to ensure that the evolution of inflation remains aligned with the current expectations of a sustained adjustment path’. The interest rate guidance suggests that the ECB will keep interest rates on hold at least until September 2019. In the press conference, Mr Draghi emphasised the term ‘at least’ and the inflation conditionality, hinting that interest could remain on hold even longer.
Uncertainty about the economic outlook
The ECB also published its June staff macroeconomic projections for the euro area. As expected it lowered its forecasts for GDP growth in 2018 (to 2.1%, down from 2.4%) and kept its forecasts for 2019 and 2020 unchanged at 1.9% and 1.7%, respectively. Although Mr Draghi said that the risks to the growth outlook remained broadly balanced, he mentioned that there had been a weakened impetus from global trade and that uncertainties about geopolitics and world trade had undeniably increased. Also he mentioned that the soft patch that the eurozone’s economy experienced in Q1 could persist longer than was currently incorporated in the projections. Subsequently, the ECB president emphasized that the Governing Council stands ready to adjust all its instruments if necessary to make sure the inflation remains on a sustained adjustment path towards its inflation aim.
With regard to inflation, the central bank raised its forecasts for 2018 as well as for 2019 (each to 1.7% from 1.4%), whereas its kept its forecast for 2020 unchanged at 1.7%. The upward revisions for 2018 and 2019 were mostly due to higher oil prices, as the projections for core inflation (headline excluding food, energy and changes in indirect taxes) remained unchanged for 2018 and 2019 (at 1.1% and 1.5%, respectively), while that for 2020 was raised slightly, to 1.9% from 1.8%. This is surprising given the ongoing lack of underlying inflationary pressures and weaker growth outlook.
Our base line scenario
Following today’s announcements, we remain comfortable with our key ECB and market views. We stick to our long-standing baseline scenario that ECB will raise its policy rate for the first time in September 2019. In addition, we continue to think that given the uncertainty about the economic outlook and weak underlying inflationary pressures, the balance of risks is skewed towards the ECB waiting even longer than in our base case. We remain of the view that German government bond yields will remain anchored closed to current levels on the 3-month horizon (2y: -0.6%, 10y: 0.5%) before rising only gradually thereafter. We also expect more euro weakness over that time period (3m: EUR/USD at 1.10).
(Nick Kounis & Aline Schuiling)