Not sure how Draghi could have been more dovish

by: Nick Kounis , Aline Schuiling

ECB View: Further monetary easing remains on the cards – Government bond yields rose, with curves bear flattening, and the euro strengthened following the ECB announcements and press conference. However, it is unclear how ECB President Mario Draghi could have been much more dovish than he was today. He very explicitly put both rate cuts and a fresh round of QE on the table and signalled that the Governing Council was ‘determined’ to act. Mr Draghi also said that downside risks had ‘gained in importance’ and said the Governing Council takes the fall in inflation expectations ‘seriously’. We remain confident in our view that the ECB will move towards further stimulus in the coming months. The ECB has made its reaction function to negative developments going forward clear, while we think that economic growth and inflation will disappoint the ECB’s new forecasts (see below). Our base line is for a restart of the asset purchase programme. If anything, the ECB’s commentary suggests that a new QE programme could be coupled with a rate cut.

Rate cuts and QE put explicitly on the table – The most interesting part of today’s communication for us came in the Q&A session of the press conference, where President Draghi gave a sense of the mood of the discussion in the Governing Council. He said that the meeting was characterised by ‘the readiness to act in case of adverse contingencies’ and that ‘several members raised the possibility of further rate cuts’, while others ‘raised the possibility of restarting the asset purchase program’. He also said that the ECB had ‘considerable headroom’ to expand asset purchases. The ECB also made it clear that it would not accept the persistence of low inflation and said it would pursue the objective in a ‘symmetric fashion’. Indeed, as well as downside risks to the economic outlook given ‘the rising threat of protectionism’, the ECB does seem concerned about the fall in market-based inflation expectations. Although Mr Draghi noted that the implied risk of deflation remained very low, he did conceded that markets attached a high probability of inflation remaining stuck at 1-1.5%.

Forward guidance extended and TLTRO rate set as low as -0.3% – Meanwhile, the ECB also announced an extension of forward guidance as well as the details of the TLTRO-III programme. Policy rates will now remain on hold ‘through the first half of 2020’ compared to ‘through the end of 2019’ before. By definition, this means a longer period of reinvestments, which will continue ‘for an extended period of time past the date when we start raising the key ECB interest rates’. The TLTRO-III lending rate could go as low as -0.3% for banks whose eligible net lending exceeds a benchmark. This is somewhat higher than under TLTRO-II (-0.4%). In addition, Italian and Spanish banks will be able to borrow very little over and above their TLTRO-II funds, while the lending rate makes it relatively unattractive for French and German banks that can. So new net borrowing under the programme will likely be limited, though Italian and Spanish banks could use the funds to avoid a repayment cliff and move to market-based funding more gradually.

ECB revises projections for growth and inflation modestly lower – The ECB published its new Staff macroeconomic projections for the euro area as well. Due to the unexpectedly strong realisation for GDP growth in 2019Q1 (0.4% qoq versus the ECB’s projected 0.2%) the central bank raised its growth forecast for 2019 slightly (to 1.2% from 1.1%). Still it acknowledged that part of the jump in growth in Q1 was temporary in nature and that growth will slow down again in the coming quarters. Therefore, the central bank reduced its projections for growth in 2020 to 1.4% (from 1.6%) and in 2021 to 1.4% (from 1.5%). It maintained its assessment that the risks to growth remain tilted to the downside. Turning to inflation, the ECB lowered its forecasts for core inflation in 2019 modestly to 1.1%, down from 1.2%, but kept its forecasts for 2020 and 2021 unchanged (at 1.4% and 1.6%, respectively). Compared to our own projections for growth and inflation, the ECB is optimistic. We have recently lowered our forecasts for global economic growth as well as growth and inflation in the eurozone (see here) and we expect eurozone GDP to grow by 0.7% this year and by 0.9% in 2020, while we expect core inflation to be 1% in each of these two years.

QE to be announced before year end – Overall, we judge that the ECB will react to a more prolonged economic slowdown by relaunching QE. Concerns about low inflation and low inflation expectations are already building even under the ECB’s more optimistic scenario, while ongoing sub-trend growth will make it more likely that inflation will significantly under-shoot the price stability goal over the central bank’s policy-making horizon. An announcement of APP-II is likely by the end of the year, with actual purchases starting in January 2020 (though it could be launched early). We assume 9 months at EUR 70bn a month and a total size of EUR 630bn. Following today’s ECB communication, we see a rising chance that there could be a rate cut in addition to the second round of QE already factored into our base case. (Nick Kounis & Aline Schuiling)