Global Daily – ECB stimulus: Triggers versus tools

by: Nick Kounis , Bill Diviney

ECB View: Inflation outlook and inflation expectations triggers for QE; euro trigger for rate cuts – FAt last week’s Governing Council meeting, ECB President Mario Draghi set out clearly that the central bank was willing to restart QE, cut rates and further extend forward guidance. This was ‘in case of adverse contingencies’ and/or to ensure that inflation ‘moves towards the Governing Council’s inflation aim in a sustained manner’. In terms of adverse contingencies, it was clarified in the Q&A that the health of the domestic economy remained a crucial issue, with Mr Draghi postulating ‘how long can the rest of the economy be insulated from a manufacturing sector that keeps on being weak? I think that’s what the Governing Council had in mind when they said they stand ready to use again instruments…’. Mr Draghi said that the Governing Council had not yet ‘discussed which contingency would call for which instrument’. However, we can gather some insight from the ECB’s past behaviour and communication.

In a nutshell, we think that QE would be re-launched due to a deterioration in the inflation outlook and concerns about a de-anchoring of inflation expectations, while a rate cut would be an instrument to fight against currency strength.

Inflation outlook and inflation expectations – Earlier this year, the ECB published a research note on the asset purchase programme (see here), which included a section on the rationale for launching the APP. In the paper, the ECB explains that the APP was designed specifically ‘to reverse the downward trend in inflation and forestall a disanchoring of inflation expectations’. In terms of the inflation outlook, the publication notes downward revisions to the ECB’s inflation projections to around 1.3% in the second year of its forecasting horizon had caused concern at the time. The ECB’s current projection for inflation over that horizon (currently 2020) is 1.6%, but it is foreseeable that further downward revisions to the growth outlook over coming quarters could also see the staff projection for inflation revised closer to the level that triggered the announcement of QE.

As for inflation expectations, it explains that options markets ‘assigned an almost 50% probability to deflation and assigned an only marginal probability to annual inflation reaching a level close to 2% or above.’ In the current juncture, the ECB President noted at the last meeting that ‘there is no probability of deflation’ but ‘certainly there is a considerable mass of distribution between zero and 1.5%’. He also made clear that ‘we are taking this seriously’. We agree with these observations on options pricing and we also note that the 5y5y inflation swap has fallen to a record low since the ECB meeting. Overall, our sense is that the ECB’s two-year ahead inflation outlook is not (yet) low enough to trigger QE, but developments in inflation expectations likely are.

Currency strength – The ECB has not been as explicit about the rationale behind cutting policy rates into negative territory, though it has pointed to the benefits to the economy of the lower bank lending rates, which were partly driven by rate cuts. So rate cuts could also be part of the response to a lower outlook for growth and hence inflation. However, a bigger driver appears to be currency strength. The euro had been on a strong upward trend on a trade-weighted basis in the period leading up to the first two rate cuts in 2014. In addition, there were signs of renewed currency strength preceding subsequent rate cuts in late 2015 and early 2016. In last week’s press conference, Mr Draghi was asked what impact Federal Reserve rate cuts may have on the eurozone economy. He said that ‘the effective exchange rate of the euro has appreciated and so I think that’s the answer to your question’ though he noted that ‘financing conditions with respect to the last monetary policy meeting have become slightly, slightly tighter’. Although the euro has firmed a bit further since the last Governing Council meeting, we judge that euro strength is not yet sufficient to trigger a rate cut. A possible step before any rate cut could be a change of the forward guidance on interest rates to include the possibility that interest rates could go lower. If the ECB does cut rates, it suggested that it could more seriously consider ‘mitigating measures’ for any possible side effects from negative rates. This is commonly thought to refer to a tiered deposit rate system (something we are sceptical about). However, more generous TLTRO terms could be an option here. (Nick Kounis)

US Macro: Damage likely already done from the Mexico tariff threat – Market sentiment has been buoyed by the deal struck between the US and Mexico to control migrant flows, thereby avoiding the imposition of tariffs threatened by the US at the end of May. While a positive development, the news has done little to change our conviction in there being a significant growth slowdown over the coming year – and in turn, that the Fed will cut rates. A precedent has been set whereby, with very little lead-time, the US can impose trade tariffs to extract concessions on a non-trade matter. Such a policy environment makes it extremely challenging for businesses to plan and to make investment decisions that depend on stable trading arrangements. Even before the latest Mexico threat, the raising of tariff rates on Chinese imports and the threat of a further escalation was weighing on the growth outlook. By raising uncertainty and causing firms to delay or cancel investment plans, the threat of tariffs has likely played a significant role in the global manufacturing sector weakness that is – with a lag – now hitting the US. Indeed, the ISM manufacturing PMI fell to the lowest since October 2016 in May, and manufacturing production contracted by 3.5% annualised in the three months to April – the weakest since May 2015. This is already feeding through to weaker jobs growth, with monthly manufacturing payrolls gains falling from an average +55k in 2018 to just +17.7k in the three months to May.

While the direct effect of additional tariffs is likely to remain small, we expect the latest ratcheting up in tensions to further weigh on business confidence and in turn real activity over the coming months. As a result, we expect US economic growth to fall to 1.5% next year, well below growth in 2018 (2.9%) and projected growth in 2019 (2.2%). Given the weaker outlook and a still-subdued inflationary backdrop, we expect the Fed to deliver three rate cuts by Q1 2020, starting with a 25bp cut in July. (Bill Diviney)