Draghi throws door wide open to December rate cut, putting ECB credibility on the line

Draghi today exceeded already dovish market expectations of further ECB easing – explicitly signalling that further easing was on the agenda for December, that a further depo rate cut was no longer verboten and revealing that some members played with the idea of easing today. Overall his message that ECB policy is one of “work and assess” (rather than “wait and see”) with committees tasked with examining the pros/cons of different options and Trichet’s “vigilant” shorthand for likely future action resuscitated was about as dovish as anyone could have reasonably expected short of actually easing today. As such a small further deposit rate cut (10-20bp from the current -0.2%) now seems likely in December in addition to the 6-12 month PSPP extension I had previously anticipated – as the 2017 inflation forecast is likely shifted closer to 1.5% from their current 1.7% (although the EUR depreciation and decline in yields after Draghi’s comments will themselves raise the inflation forecast) and the ECB aims to keep surprising dovishly. Of course, a policy of continually trying to keep ahead of dovish market expectationsin order to forestall a tightening of current financial conditions (given the fragile EA recovery) has potential downsides/complications: failure to deliver could see financial conditions tighten sharply and ECB credibility substantially undermined while they may be backing themselves into a corner over the negative yield biundary for PSPP purchases.  And Draghi noted that nothing has been decided yet, with likely considerable work required to attain GC consensus.

Draghi’s aim seems to have been to nip nascent EUR appreciation pressures in the bud (see here), in echoes of his 8 May 2014 comments (which marked the turning point in ECB policy). Indeed, EURUSD fell sharply back towards 1.11 (relative to the ECB’s apparent pain threshold of 1.14-1.16), with option-implied skews moving decisively in the direction of further EUR weakness. Bund yields also fell by reasonable amounts (2 year down 6bp, 10 year down 7bp) which is consistent with addressing the ECB’s once-again-apparent fears of real interest rate rises driven by declines in inflation expectations (see here). But the ECB is also hoping that, in an environment of the market attaching a very low probability to the Fed hiking in 2015 (see here) their fresh bout of (future) dovishness will help re-invigorate the policy divergence FX theme and hence give FX traders reasons to start reinstating the EUR shorts squeezed in recent months. While the ECB will likely be pleased with that market reaction, the potentially large downside of this strategy centred on managing market expectations (to prevent a tightening of current financial conditions, given the vulnerability of the recovery) is that disappointment in December would likely lead to a sharp EUR bounceback and adverse impacts on ECB credibility. No pressure then (as the Wonderstuff said “don’t let me down, gently, no don’t let me down at all”).

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The opening statement (which is approved by all the Governing Council members) noted that “the degree of monetary policy accommodation will need to be re-examined at our December monetary policy meeting, when the new Eurosystem staff macroeconomic projections will be available.” In turn this was because “the strength and persistence of the factors that are currently slowing the return of inflation to levels below, but close to, 2% in the medium term require thorough analysis.” I suspect, as I discussed here, this could reflect the impact of the ECB improving its forecasting model (which ECB Vice President Constancio’s Jackson Hole paper hinted at). Certainly initial results of a new model indicating less medium-term inflationary pressure would certainly be consistent with the need for thorough analysis Draghi’s apparent volte face. Inflation falling back into deflationary territory is also likely worrying them, especially given that inflation breakevens have failed to recover.

The apparent volte face on further deposit rate cuts seemed to reflect a combination of considering international experience and somewhat opaquely that the situation was different to a year ago when it was definitively rule out (technical assumptions not being met were also dropped in). Draghi seemed pretty defensive on the latter – he unprompted segued into discussing how central bank credibility should be measured by how the performance complies with objectives (rather than whether it has to backtrack on previous hostage-to-fortune comments). But it could be linked to Draghi notably focussing a great deal more than previously on my hobby horse of the low level of inflation breakevens, and their high correlation with oil prices. The ECB seems to finally waking up to the possibility that their credibility is at stake. Alternatively, it could simply be the case that, given the apparently-positive Swiss and Swedish experience, it may be an easier option than broadening the range of assets to be purchased.

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But the ECB also risks boxing itself into a corner. The prospective fall in yields in anticipation of further action means that a greater proportion of bonds will fall below the boundary for becoming ineligible for ECB purchases. So the corollary of removing the effective lower bound may be that the ECB has to suspend the negative yield boundary. Indeed, that may well have to happen even if it doesn’t follow through on the hints about deposit rate cuts.  If it doesn’t then it will have made its PSPP job harder, for the short-term gain of forestalling EUR appreciation tendencies.  While Draghi pushed back against concerns about QE scarcity effects (no such effects had been seen thus far and the ECB was lending bonds back to the market) we may be moving to a different world in which the ECB needs to be agile/flexible.

In terms of preferences for different instruments Draghi wasn’t for revealing much more than that there had been a “rich discussion” about the different instruments available. Rather he simply skipped to the conclusion that they were “ready to act if needed”, that they would be examine all incoming information (but with no guidance on the key things) and that they were open to various measures. He also revealed that a few GC members hinted at acting today but that this was “not the prevailing theme” i.e. attempting to downplay it a little.

There was also a bit of (mild) EUR jawboning: he mentioned the euro’s 8% TWI rise in recent months several times and reminded us that it was a one of the sources of downside risks to the recovery (given its significant effects on price stability and growth). One of the most intriguing aspects of the press conference is that, in discussing the lessons from abroad, he explicitly picked out the SNB’s FX intervention policy which could be taken as a broad hint that the ECB is thinking about going down those lines. But, somewhat confusingly, he also repeated the mantra that the euro is not a policy target. He also failed to acknowledge that ECB policies can themselves help rationaIise the euro’s strength: the negative rates policy has turned EUR into the pre-eminent funding currency, which has therefore appreciated in the recent “risk-off” environment. The lack of recognition isn’t surprising but the hope is that they’re encompassing these types of more complicated dynamics between now and December.

And there was more than usual focus on the need for structural reforms – following Nowotny’s recent comments about monetary policy potentially reaching its limits and fiscal policy/reforms needing to do more. Draghi noted that high EA structural unemployment predated the crisis and that monetary policy was supporting cyclical recovery but they want to turn that into a structural recovery. His pushback against the suggestion that it won’t be possible to get a cyclical recovery without the structural reforms – there should be “no doubts about policy effectiveness, irrespective of structural reform progress” given the positive impacts of ECB policy on money and credit markets – sits a bit uncomfortably against the opening statement text that “recovery in domestic demand in the euro area continues to be hampered by the necessary balance sheet adjustments in a number of sectors and the sluggish pace of implementation of structural reforms.” .

It was also notable that Draghi didn’t made much of the improvement in the ECB bank lending survey (BLS) which garnered lots of positive press headlines yesterday. That seems appropriate: while obviously better than a retracement the improvements were marginal. Moreover, all of the “real” drivers of corporate loan demand moved sideways – proving little evidence of a prospective strong capex profile (actual corporate loan growth continues to recover only slowly)

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Perhaps more surprising was the comparatively-little time devoted to China/EM – which last month was apparently the prime factor underlying ECB dovishness. Specifically, apart from the opening statement discussion of domestic strength versus China/EM weakness the relatively short segue actually sounded relatively benign. Direct trade linkages were described as manageable (“only” 6% of EA exports go to China, rising to 10% for Germany – but I prefer to focus on the wider AxJ region where exposures are higher, see HERE), not much was added on the indirect channels of oil/commodity prices, there were “not very significant exposures” via financial channels, and thus far EA confidence hasn’t been hit by China. On the latter the Draghi may be tempting fate: this afternoon’s advance estimate of the EC Consumer confidence survey again disappointed, and continues to lag substantially its UK and US equivalents.

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Draghi also refused to be drawn on the likely impact of the VW emissions scandal (see here for my discussion of how the IP/GDP effects could be significant, although the price-discounting effects could also be worrying the ECB), saying it was “very early to say, we will get full visibility eventually”. Not very helpful, although tomorrow’s flash PMI data seem likely to be adversely impacted. He also didn’t want to comment on political tensions in Spain and Portugal – see here for my take on the latter.

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