The major headline for the market from the ECB minutes was the comment about the euro exchange rate. The ECB’s comment suggests it was fine with a EUR/USD exchange rate rising to 1.15.
However, since the July meeting, the EUR/USD exchange rate has increased further and the trade weighted euro is almost 5 percent above the level of the latest ECB staff projections.
This could lead to downward revision of the ECB’s staff inflation projections. We see the above statement as a first slight verbal intervention to keep the euro from appreciating further. Besides the comments on the euro, the minutes contained several other important points.
The minutes suggest that the ECB could extend the program significantly longer if the outlook for price stability deteriorates. “At the same time, it was underscored that the asset purchase program would continue to be a key instrument if the Governing Council assessed the sustained adjustment of inflation to be at risk, while the use of other instruments, within the ECB’s mandate, could not be ruled out,” the minutes said.
While this comment might be correct for the corporate bond and the covered bond purchase program, the issuer limit constraint makes a significant extension of the public sector (sovereign bond) purchase program (PSPP) unlikely in our view. We continue to expect a wind down of the PSPP in the first half of 2018.
The ECB also highlighted in the minutes that the degree of monetary policy accommodation is not only defined by the asset purchase program. Negative rates and forward guidance are the other key measures within the ECB’s arsenal.
The ECB, in our view, believes that tapering its bond purchases is not tightening policy. The ECB sees it as rather a reduction of the additional policy easing. We disagree with this view. Ending QE is a form of tightening policy in our view.
The view is also consistent with another point made in the minutes: “In this context, it was also suggested that the stock versus flow effects of asset purchases be considered.”
Central banks continue to believe in the stock effect. Market participants, however, care about the flow. In their assessment, policy tightening happens when the purchase pace is reduced.
Reinvestment flows can dampen the effect of a reduction in purchase pace but they cannot substitute the net purchases. The Fed’s taper tantrum experience indicates most of the adjustment in real rates happens when the end of asset purchases is indicated.
The ECB minutes also showed a significant debate about adjusting the forward guidance more timely and gaining more flexibility within the forward guidance: “The point was made that, looking ahead, the Governing Council needed to gain more policy space and flexibility to adjust policy and the degree of monetary policy accommodation, if and when needed, in either direction.”
This suggests the ECB will substantially rewrite its forward guidance when it adjusts its monetary policy stance.
We believe the most likely date to do this is at the Sept. 7 policy meeting, when the ECB gets its new staff projections. October is also possible if the ECB needs more time to form a consensus and also likes to get past the Fed policy meeting in September, in which we expect the Fed to announce the start of its balance sheet reduction.
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