ECB View: ECB expects inflation to remain below the target until the end of its forecasting horizon – During the first Governing Council meeting under the leadership of Christine Lagarde, the ECB kept its policy rates, as well as its forward guidance unchanged. The central banks still expects ‘rates to remain at their present or lower levels’ until it has seen the inflation outlook ‘robustly converge to a level sufficiently close to, but below, 2% within its projection horizon’, and ‘such convergence has been consistently reflected in underlying inflation dynamics’. Also, it kept the amount of monthly asset purchases at EUR 20bn and expects the purchases to run ‘as long as necessary to reinforce the accommodative impact of our policy rates, and to end shortly before we start raising interest rates’. The central bank asserted that eurozone growth dynamics remained weak and inflation pressures remained muted. Still, ‘there are some initial signs of stabilisation in the growth slowdown and a mild increase in underlying inflation’. The risks surrounding the growth outlook remain tilted to the downside, but ‘have become somewhat less pronounced’, according to the ECB statement. Still, during the Q&A following the introductory statement Ms Lagarde said ‘we have relatively weak growth, let’s face it’, which suggests that the ECB is not very convinced that growth will pick up soon.
The central bank published its new staff macroeconomic projections. These showed that growth is expected to move from the current weak levels towards potential in 2020 and 2021. Annual GDP growth is expected to be 1.1% in 2020 (revised lower from the ECB’s previous forecast of 1.2%), and 1.4% in both 2021 and 2022. The outlook for headline inflation is a gradual rise from 1.1% in 2020 to 1.4% in 2021 and 1.6% in 2022 (core inflation is expected to be 1.4% in 2021 and 1.6% in 2022 as well). When asked whether the ECB’s new inflation projections would be in line with the ECB’s target, Ms Lagarde replied that the expectation for the final quarter of 2022 was 1.7%, and that ‘this is directionally good, but is it the aim we pursue? No, indeed’.
Looking forward, we expect the current weakness in growth to persist in the first half of 2020, whereas the ECB’s projections are for a pick-up in growth. Combined with the outlook of a continued inflation undershoot, this should result in some further policy easing. Indeed, we think that the ECB will decide in March to cut the deposit rate by 10bp and step up the pace of the asset purchases to EUR 40bn a month from April 2020. In addition, we expect a further loosening of the terms of TLTRO-III.
Before the start of the Q&A, Ms Lagarde tried to make several points with regards to her communication style and the upcoming strategic review of ECB policy. To begin with, she is neither a dove or a hawk, but sees herself more as an ‘owl’, thus signalling that she is more open-minded in taking different views into account. Even the planned strategic review is expected to take perspectives from beyond the ‘usual suspects’ in the realm of central banks to show its ‘commitment to EU-citizens’. The strategic review is planned to start in January and to be finalized by the end of 2020.
During the Q&A Ms Lagarde gave some more flavour to her views and thinking. Firstly, when responding to a question on what her take is on the difference between what market based inflation expectation measures are showing in comparison with the ECB’s projections, she mentioned that she looks at all measures of inflation and particular the ‘directionality of the inflation path and trend’. She also mentioned that the strategic review would take into account the definition of inflation used by the ECB. For example, by looking at whether housing and land asset values should also be taken into account.
Secondly, as part of the strategic review, the ECB also plans to analyse the impact of its monetary policy on inflation dynamics. Given the fact that the last review was done back in 2003, Ms Lagarde believes it to be ‘legitimate’ to assess its ‘effectiveness’, ‘efficiency’ and ‘and the results it delivered’. Thirdly, assessing which monetary policy tools are most effective in combination as a package will also be part of the strategic review, where Ms Lagarde explicitly took forward guidance as an example of an effective policy tool. We think that the effectiveness of forward guidance strongly hinges on central bank credibility, which has been deteriorating with subsequent years of inflation undershoots compared to ECB projections.
All in all, we judge that Ms. Lagarde sounded more like a ‘slightly hawkish owl’. Her comments on the strategic review opens up the possibility that changes in the definition of inflation could help the ECB in assessing that inflation could be closer to its mandate than currently assumed, thus artificially securing the credibility of the ECB. Additionally, we think that the review could make it more difficult to assess the ECB’s monetary policy responses beyond 2020, which would negatively impact the transparency of ECB monetary policy in Ms. Lagarde’s first year as ECB chief. (Aline Schuiling & Fouad Mehadi)