Thursday 12 September 2019 9:25 am Markets Talk

How much stimulus will the ECB deliver?

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A great showman always leaves people wanting more. In his penultimate showpiece, ECB chief Mario Draghi may do exactly that.

Expectations ahead of the European Central Bank (ECB) meeting are running very high. Whilst it seems the ECB will throw the kitchen sink at slow growth and persistently lacklustre inflation, markets seem to want the taps, the plug and the plumbing thrown in for good measure too. Indeed, former vice president Vitor Constancio said only last week that markets are expecting too much from the ECB.  

Faced with persistently weak inflation, falling industrial output and the ongoing US-China trade war, there is nothing left for the ECB now but announce an aggressive stimulus package, particularly as it very much set up the market for a big push in September. It faces a dilemma in that there are very real concerns about the efficacy of such measures. But failure to try to match market expectations would lead to an appreciation in the euro that would make achieving its goals all the harder. 

The fundamental question is whether this will work. We are dealing very much with diminishing marginal returns from easing as rates are at the zero lower bound.  Monetary policy is almost exhausted – it’s time for the politicians to step up to the mark and deliver too. First and foremost, Germany needs to spend more and stop exporting deflation. 

July recap

Markets were left a little bit disappointed in July – but should they have been? To my thinking it ought to be the ECB that should feel aggrieved as the market didn’t pick up on very dovish signals.  

As we noted at the time:  Markets have lusted for more easing and he’s come good. Having said in 2012 he would do ‘whatever it takes’, Draghi has delivered one final gift to the ECB with a new policy direction that his successor will carry forward. It’s not quite as dovish as we thought it might be in that there was no policy change today, but it sends a very clear signal. 

Having teed it up, the ECB will be pushing on an open door, but the market wants it to charge through and break the door down. 

Several things were noteworthy about the July meeting. Firstly, the ECB changed its tune on forward guidance and said it expects interest rates to remain at their present or lower levels at least through the first half of 2020. This very much opened the door to a rate cut in September. 

The ECB also underlined the need for a highly accommodative stance of monetary policy for a prolonged period of time, as inflation has been persistently weak. This addition to the statement signals there is absolutely zero chance of normalisation any time in the near future. 

And on QE, the ECB made it abundantly clear it is ready to launch a new net asset purchase programme this year. 

QE, rates & forward guidance 

The ECB is likely to announce 20bps of cuts to the deposit rate and commit, or at least leave open the possibility, to do more. Cutting the deposit rate further would of course make its TLTRO III programme more appealing. 

A 10bps would be a little short of expectations. Expect 20bps of cuts pencilled in for this year and a change to forward guidance that indicates further cuts. If it goes full kitchen sink, 20bps in cuts now and another 20bps before the year is not out of the question. We should also expect an announcement on tiered deposit rates to soften the impact on banks. It’s worth nothing that concerns about bank profitability (or even worse) may force the ECB to rein in its natural instincts to cut heavily. The main refinancing rate and marginal lending rate are likely to be unchanged. 

QE seems more open to debate, although I would err on the side of the ECB announcing it will restart bond buying in October. There are conflicting reports about whether the ECB announces a new QE scheme or simply gives a very strong indication that it will do so in December. Given what’s priced into the market, if there is no QE we could well see the euro appreciate.  

The introduction of QE would naturally require the change in forward guidance, likely on the basis of past form to say that rates will remain at current or lower levels until well past the end of net purchases. The ECB could go further and suggest a likely and more precise timeline to when rates might rise, or even link explicitly to an inflation target. 

Staff projections

There has been precious little in the Eurozone high frequency eco data to suggest improvement of late, albeit the August composite PMI nudged higher. I would be very surprised, therefore, not to see lower projections for both growth and inflation. In all likelihood these will be small adjustments but this is a necessary requirement to support the more aggressive easing policies.  

The June 2019 projections indicate real GDP growth of 1.2% this year and 1.4% in 2020 and 2021. The latest composite PMI data suggests growth of 0.2% in Q3, following the 0.2% growth registered in Q2. When added to concerns about the impact from trade wars, the projection for 2019 could fall as low as 1.0%. 

Elsewhere, the data from Germany makes for grim reading with manufacturing PMI softness and industrial production slumping. Moreover, risks from such arenas as the trade war and Brexit seem to be growing rather than abating, which will undoubtedly weigh on the quarterly projections for growth. 

Headline inflation in August was just 1%, while core inflation a meagre 0.9%. The 5y5y forward inflation swap is still only mildly above 1%, indicating the market has no confidence of inflation rising from the current lacklustre level. Estimates for 2019 of 1.3% for headline inflation and 1.1% for core inflation are likely to decline by 0.1-0.2 percentage points each. 

In short

The ECB could disappoint the market, but only because the bar is set so high. If the ECB fails to meet market expectations, the euro could appreciate through $1.11, though any upside is going to be capped by expectations of more to come down the line. Mr Draghi will leave the audience thirsty for a little more.