Global Daily – ECB: Further dovish shifts on the cards

by: Nick Kounis , Aline Schuiling , Fouad Mehadi

ECB View: Further outlook downgrades to trigger shift on rate guidance in coming months – As expected, the ECB kept its policy rates unchanged at its December Governing Council meeting. It also kept its forward guidance on interest rates unchanged, and continues to expect 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 the continued sustained convergence of inflation to levels that are in line with the ECB’s target over the medium term’.
Also in line with expectations, the central bank announced that it will end its net asset purchases under the APP programme in December. However, it did enhance its guidance on its reinvestment policy. Whereas the ECB previously intended to ‘continue reinvesting, in full, the principal payments from maturing securities purchased under the APP for an extended period of time after the end of our net asset purchases’, it now has changed this to ‘for an extended period of time past the date when we start raising the key ECB interest rates’. By changing this forward guidance, it has given more clarity about the sequence of its potential future policy tightening measures.

In the accompanying guidance on APP reinvestments, the ECB confirmed that it would bring its PSPP portfolio ‘into closer alignment’ with the updated ECB capital key, but that any adjustments would ‘be gradual’ and ‘calibrated as appropriate to safeguard orderly market conditions’. We judge that the ECB will apply the new capital key for the estimated reinvestment amounts as recently published. Initially, they would reinvest maturing bonds roughly within three months, however, in the details published today, the central bank mentions that ‘reinvestment of principal redemptions will be distributed over the year to allow for a regular and balanced market presence’. This gives the ECB the opportunity to smooth the purchases over a longer time frame, enabling them to find the necessary bonds to purchase, as for some countries this will be mainly focused on new supply. In short, it does seem at first glance that it will not be possible to reinvest maturing bonds entirely in the same jurisdiction, as this would hamper the transition to the new capital key.

With regard to other policy instruments, ECB president Mario Draghi mentioned during the press conference that several members of the Governing Council had mentioned TLTROs during its meeting. He added that the ECB intends to keep liquidity as available as it needs to be, that the Council is aware of the factors that will affect liquidity in the next couple of years, and that it will discuss this at some point in future. We expect changes to the TLTRO programme in March, to allow banks to repay the funds over a longer period than currently.

New growth projections only slightly lower; further downward revisions likely. In its new Eurosystem staff macroeconomic projections for the euro area, the ECB revised the outlook for economic growth slightly lower. It now expects growth to be 1.7% in 2019 (revised from 1.8%) and 1.7% in 2020 (unrevised). It has added the year 2021 to its forecasting horizon for the first time, and projects growth to be 1.5% in that year. The central bank maintained its view that ‘the risks surrounding the growth outlook can still be assessed as broadly balanced’. Still, Mr Draghi signalled that the ECB’s conviction in its own growth forecasts has declined. He mentioned that ‘the balance of risks is moving to the downside, owing to the persistence of uncertainties related to geopolitical factors, the threat of protectionism, vulnerabilities in emerging markets and financial market volatility’. Indeed, we think that more downward revisions to the ECB’s next staff projections will follow. Our own forecasts for GDP growth are 1.4% in 2019 and 1.3% in 2020.

Forecasts for core inflation revised lower … again. The ECB revised its projections for headline inflation in 2019 slightly lower (to 1.6% from 1.7%), kept its forecast for 2020 unchanged at 1.7% and added the year 2021 for the first time (1.8%). More importantly, however, the central bank revised its forecasts for core inflation downward more significantly. It now expects core inflation to be 1.4% in 2019 (revised from 1.5%) and 1.6% in 2020 (revised from 1.8%). Its first projection for 2021 is 1.8%. With these new forecasts the central bank has stuck to the tradition of initially forecasting core inflation to be close to the target in the final year of its forecasting horizon, and subsequently lowering it as time progresses. Considering that there is still significant slack in the eurozone labour market and that GDP growth will probably be close to trend in the coming years, we expect the ECB to further revise lower its forecast for core inflation in its next projections. Our own forecasts are 1.2% for 2019 and 1.5% for 2020.

Our base case for the ECB – We expect the ECB to keep interest rates on hold next year. We expect the forward guidance on interest rates to change following further downgrades to the outlook, and we think that the central bank will signal that interest rates will be left on hold through 2019 by the June meeting. We expect a 10bp hike in all the policy rates in March 2020 and a second 10bp increase in September 2020 (with all policy rates moving in sync). We do not expect the ECB to end reinvestments until late in 2021. Finally, we expect a TLTRO extension to be announced in March 2019. (Nick Kounis, Aline Schuiling and Fouad Mehadi)