ECB View: Large-scale fiscal stimulus is unlikely to come through, while markets were not impressed with the package – In the months running up to last week’s Governing Council meeting, the ECB stressed its dissatisfaction with the inflation outlook and stressed its willingness and determination to act. The aim was to get inflation back to the goal over the medium term and re-anchor inflation expectations at levels around that goal. On this basis, the package fell short of Mr Draghi’s rhetoric. Perhaps the clearest indication of this is that the ECB’s economists expect inflation to be at 1.5% in 2021, whereas the ECB’s President clarified in July that the central bank is aiming at 1.9%. Indeed, he himself made it clear that the Governing Council was still not satisfied with the inflation outlook. The monetary easing from the package is also mostly baked into these projections given that the impact on markets had already taken place in the months leading up to the meeting. Indeed, financial conditions tightened following the announcement. That raises the question why the ECB did not put in place a bigger package of measures?
The obvious answer is opposition in the Governing Council. Given their statements before and after the meeting, it is clear that the governors of the central banks of Germany, the Netherlands, Austria and Estonia and Executive Board member Sabine Lautenschlaeger were against the package that was announced, especially the resumption of net asset purchases. They are the usual suspects in terms of opposition to ECB unconventional policy, though Bloomberg News reported that the opposition was broader this time. According to the news agency, the Governor of the Banque de France, and Executive Board member Benoit Coeure also dissented.
This opposition may have restrained Chief Economist Philip Lane in the size of the net asset purchases that he proposed to the Council. Against this background, the ECB seems to have gone with a more modest package and gambled on the necessary stimulus coming through in two respects.
First of all, although the size of net asset purchases was modest, Mr Lane may have hoped that the open-ended nature of the announcement would have created the necessary ‘shock and awe’. This gamble looks to have failed, as investors focused on the small size of monthly purchases and concluded that even if they lasted a very long time, the additional impact on the stock of purchases would not be large enough.
Second, and much more explicitly, the ECB hopes fiscal stimulus will soon re-enforce monetary stimulus, to provide a sufficient boost to economic growth and inflation. Mr Draghi was very clear on this point saying that it was now time for fiscal policy ‘to take charge’. The jury remains out on whether fiscal stimulus will arrive, but there are few concrete signs of this right now. The German government has said it would only put in place a fiscal stimulus package if there is a ‘crisis’, while the Dutch government seems likely to put in place only modest stimulus. Indeed, at an informal Ecofin meeting over the weekend, no progress was made in reform of the fiscal rules and there was disagreement on the need for fiscal stimulus.
To improve the economic outlook in a way that significantly closes the inflation gap, perhaps a fiscal stimulus of 1-1.5% GDP would be needed on the eurozone level. That does not seem very likely. The ECB may rightly wish that central bank stimulus was not ‘the only game in town’, but that looks likely to remain the case.
So where does that leave the ECB? That leaves the ECB in a situation that inflation is likely to significantly undershoot its forecasts over the next two to three years even after the package of measures it has just announced. The situation may become more challenging. First, financial conditions have already tightened over the last two weeks and this may continue if investors take the view that the ECB is not willing or able to act. Second, the ECB’s growth and inflation outlook may actually be optimistic. Indeed, their projections are above our own and the central bank sees downside risk to its base scenario with the risks of recession having increased. Finally, inflation expectations look to have de-anchored (or as Mr Draghi puts it: re-anchored at lower levels) and this could further dampen inflationary pressures.
The unsatisfactory outlook for inflation combined with a significant minority on the Governing Council that opposes taking action will prove a challenge for the incoming President, Christine Lagarde. Ultimately, we think that the ECB will take further action to try and support demand and get inflation up. We would expect a stepping up in the pace of net asset purchases next year and a rate cut before the end of this year. Faced with missing the price stability goal and de-anchored inflation expectations, we think Ms. Lagarde will push through such measures despite the opposition, especially given that there is a majority for action.
In the medium to long-term, Ms. Lagarde will need to do more to improve the coherence and unity of the Governing Council about the institution’s aim and policy tools for the ECB’s monetary policy and communication to be credible and effective. As announced by the current ECB President, his successor will embark on a review of the ECB’s inflation goal and tools next year. Achieving an outcome that the Governing Council as a whole can support will be tough. Ms. Lagarde’s tenure at the ECB will be anything but a walk in the park. (Nick Kounis)
China Macro: More support likely, as weakness deepens – China’s activity data for August pointed to a further loss in momentum, showing that piecemeal support measures taken so far have not yet been successful in offsetting a rising drag from the escalated trade/tech conflict with the US. Industrial production growth dropped to 4.4% yoy (July: 4.8%, consensus: 5.2%), the slowest pace in 17 and a half years. Retail sales slowed to a four-month low of 7.5% yoy (July: 7.6%, consensus: 7.9%) and fixed investment to a one-year low of 5.5% yoy ytd (July and consensus: 5.7%). All in all, Bloomberg’s monthly GDP estimate fell to a post-global financial crisis low of 5.8% yoy (July: 6.0% yoy)
All this strengthens the case for a stepping up of (targeted) stimulus. Last month, the PBoC announced a shift in their monetary toolbox, in an attempt to create room for lower borrowing rates. In early September, a State Council Meeting highlighted that further support was on the cards, referring to RRR cuts and to frontloading of local government debt issuance to finance infrastructure projects. And indeed, on 6 September, the PBoC announced it would lower bank’s reserve requirements ratios (RRRs) by another 50 bps, in line with our forecast. The central bank has now cut RRRs by a total of 150 bp this year and by 400 bps since March 2018. The PBoC also presented a 100 bp additional RRR cut for certain city commercial banks, that are lending a lot to SMEs. Lending data for August indeed showed an improvement and generally came in better than expected (with M1 growth as an exception though, remaining low at 3.4% yoy).
We expect the PBoC to continue with RRR and interest rate cuts and the fiscal authorities to create further room for local governments to step-up infrastructure spending. That said, the authorities will likely refrain from ‘big bazooka’ stimulus, while for the time being keeping a prudent approach regarding housing market policies. For more on this topic, see our note here. (Arjen van Dijkhuizen)