My previous post encouraged my readers to listen the Draghi and Praet’s dovish comments rather than think of recent easier financial conditions as a reason for the ECB to ease less than expected. So Draghi’s powerful speech today reinforces my existing view that the ECB easing on 3 December is likely to exceed market expectations (although the latter may well catch up with my view). Indeed, the combination of Draghi’s description of weak EA growth momentum as “striking”, his concerns about wage-inflation dynamics in the “prolonged downturn” conditions and argument that deposit rate cuts “empower the transmission of APP” support my view that the 10bp deposit rate cut expected by the market may well be exceeded (I’ve long thought that a 20bp cut is possible, see here). Limited EURUSD downside seems likely into year-end on the ECB-Fed divergence theme, with a 1.02-1.04 likely but parity a tougher ask.
The headline sentence was: “If we decide that the current trajectory of our policy is not sufficient to achieve that objective, we will do what we must to raise inflation as quickly as possible”. But there were a number of notable points.
First, Draghi’s apparently greater focus on weak EA growth momentum, which is “striking” given that the economy is coming out of recession (when above-trend growth normally happens) and has the unusual tailwinds of exceptionally-easy monetary policy and oil price falls. While the deteriorating international environment was one of Draghi’s three risks, “even factoring in those headwinds, the strength of the underlying recovery is modest”. This somewhat contrasts with the tone of Draghi’s opening statement at the 22 October press conference, which noted that “euro area domestic demand remains resilient”. One explanation is that the EA staff have been having a longer look at the data (on Monday Peter Praet described the examination as “holistic”), perhaps through the lens of an updated staff model (here).
Second, Draghi was more worried than previously about the EA’s prolonged downturn and the consequent potential adverse impacts on wage-price setting behaviour. Even if the ECB’s (optimistic) September forecasts prove accurate GDP it will have taken a worrying 31 quarters to re-attain pre-crisis GDP levels (in 2016Q1). I’ve long-worried about where wage pressure is going to come from with EA unemployment at 11% and weak survey indicators of labour demand (see here).
So the third notable development was that Draghi pointed to subdued wage pressures as the driver of near all-time low core services inflation (which won’t receive as much support from the euro’s fall as core industrial goods prices). Indeed, his argument that a wage pickup requires the economy to “move back to full capacity as quickly as possible” indicates that they’re getting more worried about hysteresis effects and so are contemplating aggressive action on 3 December. Eliminating the likely large EA output gap is a much tougher task than merely raising EA growth from its recent below-trend levels: Draghi seems to be aiming for above-trend growth (good luck!). The potential for aggressive action was also supported by Draghi’s comment that “we will not ignore the fact that inflation has already been low for some time.” As I expected he was also pretty dismissive of the small recent small (core) inflation rebound (“Low core inflation is not something we can be relaxed about”).
But Draghi rolled out a further new policy argument in stating that a deposit rate cut can “empower the transmission of APP” i.e. make the existing purchases more impactful. His justification was that this operated “not least by increasing the velocity of circulation of bank reserves”. This raises my confidence that any ECB surprise on 3 Dec is most likely to come via a greater than expected deposit rate cut. As I’ve noted for a number of weeks, a 20bp cut is entirely conceivable, and is now becoming more my central case. Indeed, that may be an easier sell to GC members who were reluctant to start QE than an aggressive QE expansion or extension (although I still expect a 6-12 extension, with the potential eventual addition of municipal bonds).
The overall aim of the speech seems very much to have been to convince the market that the ECB has plenty of firepower left (including new variants), that it won’t hesitate to use it and that the ECB policies thus far had been beneficial: (i) QE was argued to probably be the dominant force spurring the recovery and was “instrumental in arresting and reversing the deflationary pressures”; (ii) Draghi countered criticisms by arguing that “the power of transmission through the banking system has been rising through the life of our programme”. Here he’s obviously treading a difficult line given that he’s also now focussing on the downturn having been more prolonged and the weak growth momentum being “striking” in light of the tailwinds from ECB easing and oil price falls. So he concluded that the issue was one of “calibration”: in plain speak, have they yet done enough. I remain
Draghi’s other strategic aim may well have been to maintain the downward pressure on the euro. Of course the official ECB line is that they don’t have a EUR target but (G20 commitments and all that). But since early 2014 Draghi has been reminding markets about the large impacts of EUR moves on the ECB’s inflation forecasts and fresh bouts of ECB dovishness have often followed periods of EUR strength. EURUSD dutifully declined 0.7% today, back below 1.07 after two days of edging up (traders were reported as adjusted positions, perhaps reflecting doubts about whether the ECB would really follow through on their rhetoric). We’re likely to see a continued barrage of GC member comments over the next nine working days fortnight as the market may well see .
I continue to expect further (limited) EUR downside into year end on the ECB-Fed policy divergence theme. Indeed, a further benefit for the ECB of the larger deposit rate cuts which they seem to be edging towards is the likely larger EUR impact than a QE extension (as well as being more likely to jump start EA animal spirits, see HERE). But given that ECB action has been increasingly priced in, I’m not convinced that EURUSD parity will be reached by year end: 1.02-1.04 seems more likely (and that itself will likely require market risk appetite to hold up so that EUR-funded carry trades aren’t unwound).