ECB monetary policy account to highlight sensitivity to downside risks (VW crisis a fresh macro risk)

In the following I discuss what we might learn from Thursday’s ECB monetary policy accounts, reiterate my view on the likelihood of ECB easing (likely in December) and offer some thoughts on the potential adverse macro impacts of the VW diesel engine scandal.

ECB monetary policy accounts

Thursday’s ECB monetary policy account (minutes) will be carefully examined by the market for signs of: (i) just how far ajar the door is for further ECB easing and the modalities of any easing; and (ii) how much weight the GC placed on the relatively sharp market movements which occurred in the two weeks after the 12 August cutoff date for the staff forecasts which helped motivate downside risks to the weaker GDP and inflation forecasts i.e. how much further potential dovishness is on display.

It may well be that we don’t get much marginal information on (i), given Draghi’s responses to questions in the press conference. Recall that Draghi dovishly emphasized the GC’s willingness and ability to act by adjusting the size, composition and duration of the PSPP (with the increase in the PSPP issue limit from 25% to 33% illustrating such flexibility). But when asked about the prioritisation of those different options he responded that the question was not discussed, given that “we aren’t there yet”. And he separately said that the option of a deposit rate cut was not discussed (although his clarifucation that they hadn’t discussed the answer to the question of whether interest rates have reached their lower bound may give a bit of wriggle room). Despite apparent growing market speculation on rate cuts the potential credibility hit associated with doing a policy U-turn of further rate cuts militate against it.  Finally, Draghi was clear that there were no discussions of raising the size or pace of the PSPP straight away, so we shouldn’t expect any hints about individual GC members getting itchy fingers.

But the minutes should contain more colour on (ii), given that Draghi drew attention to the 12 August cutoff date for the staff forecasts (hinting at the risk of stale forecasts and helping motivate the downside risks to the forecasts). The opening statement was clear that the GC judged it premature to conclude whether the more recent developments would have a lasting impact on prospects. But we may nevertheless get some nuggets on the range of views within the GC. And they may well offer a sense of the discussion around the downward revisions to GDP and inflation in the updated staff forecasts along with GC members’ sensitivity to downside risks crystalizing. My bottom line is that there will likely be text suggesting a relatively high sensitivity to downside inflation risks (i.e. relatively low barriers to further easing) given worries about inflation expectations de-anchoring in an environment of low inflation persisting for a number of months. Draghi was open in the press conference that there could be negative headline inflation outturns in the coming months, but that the GC tends to think of them as transitory effects (to be looked through) due to oil price effects. That suggests that ECB won’t be overly concerned about last week’s fall back into negative headline inflation (-0.1% yoy) per se, although they’d probably have prefer to see core inflation heading up rather than flatlining at 0.9% and the minutes may well signal concerns about the low level of EZ inflation breakevens.

But overall the GC will likely want to use the minutes to send a dovish, albeit lagged, message about the possibility of further easing – in order to reinforce the message in the minds of market participants and forestall any nascent EUR appreciation pressures (which seems to have risen in their priorities, see here).


ECB easing likely in December

My regular readers will recall that I’ve been arguing for additional ECB action for a while (when the market was romancing the reflation theme). Developments over the past month haven’t dissuaded me from the big-picture view I discussed here that the ECB’s inflation forecast looks overly-optimistic and rife for further downward revision in December.  And that would open the way to an PSPP extension, probably of 6-12 months initially.

More specifically I remain concerned about EA growth underperforming other countries and inflation remaining weak given that:
• Weak labour market dynamics mean that strong wage/inflation pressure is unlikely to be generated – the chart below shows that Germany is the only big EA country with half-decent wage inflation, unemployment remains persistently high in a number of member states and the ECB is only forecasting a small fall in the EA unemployment rate from the current 11%.
• Consumer confidence isn’t that great (significantly weaker than in the UK) – although I discuss here how strong M1 growth may presage continued OK retail sales growth.
• Corporate loan dynamics remain pretty weak big picture, despite some recent improvements, raising the question of whether the “credit impulse” will be sufficient to support the investment recovery essential to ensure the sustainability of the recovery.  High exsiting debt burdens (lack of deleveraging) also likely represent a constraint on the demand for credit (see here).
• Inflation breakevens remain low and fragile (risk of ECB losing credibility) – and real interest rates look commensurately inappropriately high.


• While EURUSD has recently been range-bound the EUR TWI has fallen back less from its August peak and risks rising further if the ECB disappoints dovish market expectations or if market risk appetite takes a major hit (e.g. driven by a major China slowdown) given the funding currency nature of the euro after ECB easing.
• EA PMIs remain uninspiring, with the previous Spanish outperformance coming to an end (alongside the Bank of Spain downgrading near-term growth prospects) and France remaining the underperformer which would benefit from further structural reforms but probably won’t get them before the scheduled 2017 election.


The EA’s exposure to China/EMs seems to be showing up more in the data.  I discussed the EA’s overall exposure in July and Germany’s disproportionately larger exposure in August. And its notable that German factory goods orders from non-Eurozone countries have been very weak in the past couple of months, consistent with the relative importance of asian markets for German exports.  So Thursday’s German export data will be interesting.  Moreover, this weakness of German factory goods export orders have been particularly apparent for motor vehicles – and the likely adverse impacts of the VW diesel engine scandal which I discuss further below will likely exacerbate. Moreover, the weakness in German factory goods orders translated into sharp fall in German industrial production in September, altough German FSO highlights that the timing of holidays also contributed.  But it’s notable that Spanish industrial production was also pretty weak in September.


VW Scandal: potential macro impacts through several channels

Another prominent development since the September ECB meeting has been the growing scandal of VW installing regulation-cheating software to their diesel engines, affecting around 11 million cars worldwide (including Audi, Seat and Skoda). Obvioulsly there has already been a 30% fall in the VW share price, imposing wealth losses on equity-holders.  But there may well be further adverse macro impacts through several channels, which may start concerning the ECB.  Given the difficulty in precislely quantifying the impacts (given the range of possible scenarios depending on how consmers react) below I set out the broad channels and some suggestive metrics.  But overall it seems likely that that German industrial production, exports and GDP will suffer reasonable hits in the following months given the relatively prominent roles of auto production within them. I’m inclined to think that other German and European auto manufacturers would feel some offsetting benefits as consumers substitute brands, although that could be less the case in export markets (possible greater chance of all euopean manufacturers being suspected). So there may well be impacts on eurozone GDP which the ECB will also have to consider.

(a) Cost-cutting measures by VW

The new VW chief Poetsch has already warned that the scandal could represent an existential threat to the company, that the initial €6.5bn provision probably won’t be enough (say hello to US litigation) and consequenly all non-essential investment spending will be reviewed and there could be job losses or weaker pay growth (relative to the counterfactual). The potential for a large impact is illustrated by VW’s reported $17.4 bn 2014 R&D spending – the largest of any corporate in the world (around that of Apple and Google combined).

(b) Lower VW (German/European) car sales – both domestic and exports

The most obvious impact is via lower VW or German car sales and hence lower German IP and exports – as domestic and foreign consumers delay or forego purchases of VW-group cars, switching to other brands in the latter case. But there’s considerable uncertainty about the scale of the impacts.

First consider the experiences in previous high-profile car problems.  Toyota’s 2010 recall of around 9 million vehicles to fix the “unintended acceleration” problem resulted in a halving of sales in the following month, partly because sales of affected models were suspended and production temporarily shut down. But sales recovered relatively quickly thereafter. By contrast, GM’s 2014 ignition switch related recall of around 27 million cars had much smaller sales impacts, although the affected cars were not current models and the issue was not potentially deadly.  So the truth lies somewhere in-between in the current scenario: perhaps a 20-40% fall in VW diesel car sales for a 3 month period (given that the issue is likely to take a while to sort out) as a conservative guesstimate.  Given that diesel cars made up 56% of VW production in 2013 (see here) that suggests a 10-20% drop in VW car sales, although that might represent a lower bound given the potential for VW-group petrol cars to also suffer a reputational hit.  And the impact could be longer lasting than in the Toyota example given the apparent deliberate VW actions (hence the concerns about the ) which will require significant reputation rebuilding (and likely lower margins while that happens).

The likely adverse impact on German industrial production is illustrated by car production’s starring role in German output in recent years, with the 40% cumulative rise since start-2010 being at least double that of other manufacturing sectors (see Chart).  And ACEA data illustrate that VW production made up a large part of that success story: VW production accouts for 55% of the EU registrations of German automakers.  Of course, there would be no overall impact on German industrial roduction if either consumers switch from VW diesel to VW petrol (the minimal impact on VW!) or if previous VW customers switched to other German manufacturers (Mercedes, BMW, Opel).  But neither seems particularly likely, given the smaller size of the other German producers and the often different market segments.  So it seems likely that German auto production and IP will take a hit – with no subsitution into other German brands that would be 6-12% fall in German auto production that could persist for a number of months as VW invests in rebuilding its reputation.


There may of course be some offsetting benefits to other EA manufacturers if consumers decide to switch into e.g. French or Italian cars which would reduce the impact on EA auto production and IP.  But there’s no real way of knowing ex ante whether consumers might instead decide that either all european cars are suspect or just forget about buying any new car (until the dust has setted).  So there could equally be negative spillover effects – perhaps especially in non-EA markets.

But sticking narrowly with German exports, the fact that motor vehicles account for around 18% of German exports (see chart below) again suggests the potential for a resonably-large hit to total German exports.  And as disussed above foreign orders for German car exports were falling in July and August (i.e. before the VW scandal broke), seemingly because of the slowdown in Asian markets.  So there could be a double-whammy effect here. That will making it difficult to separate out the two seperate effects, but the data should neverthless be monitored carefully. The chart below illustrates that net exports more than accounted for Q2 German GDP growth (0.7pp contribution to the 0.4% qoq increase) offsetting a slowdown in consumption growth, a 0.4% qoq fall in fixed capital formation and a marked drop in inventories.  So the likely hit to German exports in the months ahead could see German GDP dip if German fixed investment doesn’t rebound (which now seems more likely given the probably hit to VW investment discussed above) or if consumption doesn’t regain its previous strength (which seems less likely given the strength of the German labour market).


(c) Rectifying the problems – potential delayed offset

VW obviously have a huge task ahead of them fixing the problem.  Doing so will tend to raise industrial production, although VW obviouly will be obviously be paying for it out of their reserves.  And the apparent plan to start he repair work in January 2016 means that any IP offset will occur after the likely initial hit to auto production and IP from lost sales. VW will obviously be hoping that that the fixes are largely software, and that customers are prepared to live with the likely worse fuel economy.


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