The European Central Bank (ECB) has rattled markets with a paragraph in its latest minutes noting that its forward guidance is likely be changed along “various dimensions” early this year. In particular, it stated that the “relative importance of the forward guidance on policy rates would increase” – i.e. how long policy rates can be expected to remain at the current level.
It also intends to “transition gradually from the present conditionality focused on APP (asset purchase program) net purchases to a broader concept of forward guidance comprising various dimensions of the monetary policy stance”. In addition, the minutes showed that “communication should be adjusted gradually over time to avoid sudden and unwarranted movements in financial conditions”.
From the above language we conclude the following:(1) Gradual adjustments to ECB communication mean that the central bank chief Mario Draghi will comment on the Governing Council’s (GC) evolving thoughts on its exit strategy. He cannot say that they did not discuss the topic.(2) “Gradual” also means that actual changes will occur at the following meeting on March 8 or in April. Otherwise, the risk of sudden and unwarranted movements in financial conditions could occur.(3) In the next months, the ECB will take particular note of whether financial conditions have already additionally tightened through a higher exchange rate.(4) A shift of the conditionality of forward guidance on future policy rates implies that the GC considers asset purchases not to be the policy instrument of the future. As a result, purchases will either end in September or will be wound down towards year-end.
With the above points in mind, let’s have a look at what has changed since the latest ECB meeting. Hawks will argue that the main news over the past few weeks was that oil prices have increased by 7 percent in euro terms, which puts upward pressure on headline inflation and inflation expectations. They will also point out that forward looking indicators remain at very elevated levels, even if some have moderated slightly.
The hawks are also likely to argue that the labor market has improved quickly. The overall unemployment rate has fallen to 8.7 percent in November, which compares to 9.8 percent a year ago or 12.1 percent at its cyclical peak in 2013. While this is still higher than the trough of 7.3 percent right before the financial crisis, it is now lower than the average between the start of the monetary union and 2007.
The doves in the GC will also find arguments in the labor market. First, they will point out that 14.2 million unemployed are still too many. In particular, youth unemployment remains high at 18.2 percent. As a result wages are only increasing slowly. They will also argue that the euro is already appreciating too quickly. Since the last ECB meeting, the EUR advanced versus the USD by 4 percent and on a trade weighted basis by 1 percent (6 percent yoy). Some GC members have already voiced their concerns in the past few days.
Ultimately, it will be the inflation outlook that determines how fast the ECB moves forward. We expect inflation to trough in February at 1.1 percent yoy (headline) and 0.9 percent yoy (core) and to move slowly towards around 1.5 percent yoy at year-end. In our view, this warrants a less generous monetary policy. In arriving at this view we would treat deviations of underlying inflation rates from the inflation aim symmetrically. Hence, we believe the ECB should fight inflation that is too low as much as it would fight inflation that is too high. We still believe that the ECB can gradually adjust its policy stance as it would if coming from the other side.
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