ECB View: April meeting account signals concern about inflation expectations – The account of the April Governing Council meeting suggested that the ECB is not yet ready to move towards additional monetary stimulus, but if anything that is where its bias currently lies. The account notes that although ‘contingencies for the Governing Council to act again had not materialised, the point was made that inflation remained uncomfortably below the Governing Council’s inflation aim and market-based inflation expectations had receded, while the projected inflation convergence had been repeatedly delayed’. Indeed, ‘some concern was expressed that market-based inflation expectations had shifted downwards in parallel with actual inflation and across all maturities’. Against this background ‘the Governing Council reiterated its determination to stand ready to adjust all of its monetary policy tools, as appropriate’.
The Council provided a caveat to its concerns about inflation expectations, saying that ‘the deterioration was seen to mainly reflect a response to the weaker economic outlook rather than an unanchoring of inflation expectations’. This is line with the point made by several members of the Executive Board (including Messers Draghi and Coeure) that the decline in inflation expectations (as measured by the 5y5y) mainly reflected a fall in inflation premia rather than expectations. Having said that, it is difficult to disentangle these and it is questionable whether a central bank would admit that inflation expectations were no longer anchored around its goal as this is its ‘holy grail’. In addition, the 5y5y inflation swap rate is lower today than at the time of the April Governing Council meeting and is not that far from all-time lows.
What does all this mean for the ECB? The combination of weak underlying inflationary pressures, subdued economic growth (see below) and the drop in inflation expectations points to further dovish shifts from the ECB. A further extension of the forward guidance on interest rates and reinvestments seems likely at some stage and we think the terms for TLTRO-III will be generous (with the rate at -0.4%). Our base case does not factor in further easing beyond these steps, though the chances of this have risen and are significant. We think further easing from the ECB would take the form of QE rather than rate cuts. (Nick Kounis)
Euro Macro: Signs that export weakness is impacting domestic economy – Two bellwether business surveys – the PMIs and Germany’s Ifo – provided mixed news about the eurozone economy in May. To start with the good news, it looks as if manufacturing and exports are bottoming out, following the sharp deterioration in momentum over the last few months. The bad news is that there are signs that the weakness in external sector is having an adverse impact on the domestic economy.
The eurozone composite PMI edged up to 51.6 in May from 51.5 in April, a level consistent with economy stuck in sluggish growth territory (GDP growth in the 0.1-0.2% region). This supports our views that the acceleration in the official GDP growth data seen in Q1 is unlikely to be sustained. The components showed some improvement in the manufacturing sector, despite the modest decline in the overall manufacturing PMI (to 47.7 from 47.9). For instance, the indexes for new orders as well as new export orders improved, though they remain in contraction territory. This seems to be consistent with trade data in a number of key export economies in Asia suggesting that world trade could be starting to bottom out, albeit at very weak – and probably negative – growth rates.
The bad news is that the service sector PMI dropped (to 52.5 in May from 52.8 in April), while the slowdown in new business in that sector fell more noticeably (51.6 from 52.9). Adding to the sense that domestic demand might be starting to feel the knock-effects of weak exports, the employment index of the composite PMI slipped (to 52.4 from 53.2). It is still consistent with job growth, but at a level low enough to put some upward pressure on unemployment. Some easing in the labour market against the background of still relatively high unemployment suggests that underlying inflationary pressures will remain subdued. Indeed, the composite output price index fell in May (to 51.9 from 52.6) to reach its lowest level since July 2017.
Germany’s Ifo business climate indicator seemed to confirm these trends. The overall indicator dropped (to 97.9 from 99.2), driven by a sharp fall in current conditions, though the expectations index – a better indicator for GDP growth – stabilised. The sector breakdown showed manufacturing stable at low levels, but the services index fell to the lowest level since November 2014.
So where does that leave us in terms of the outlook for the eurozone economy? Our base case for the global economy is that we will see a modest improvement in the second half of the year. The dovish shifts from policymakers – from the US to the eurozone to China – have helped to arrest the tightening of financial conditions and over time this should feed through. The re-escalation of the trade war is a significant risk to this picture, though we are assuming we will see some de-escalation over the coming months (though our conviction on this point is admittedly not very high). Against this background and together with still relatively positive domestic fundamentals, we think the slowdown in domestic demand should prove limited. As such, we do not expect a further slowdown in eurozone economic growth, but rather some improvement later in the year. Overall then, muddling through with subdued growth seems more likely than recession to us. (Nick Kounis)