This piece argues that, despite recent improved €Area inflation and activity data, Draghi is likely to reiterate a highly-acccommodative ECB policy stance at Thursday’s press conference. Contrary to growing market discussions, the ECB is very unlikely to drop it’s forward guidance text on potential further rate cuts as it remains focussed on subdued core inflation and committed to QE purchases of €60bn a month until at least December. Overall it remains too soon for the ECB to be reasonably certain that there’s been a sustained pickup in €Area inflation and they won’t want to risks generating an unwarranted tightening of financial conditions or damaging their credibility. The main detailed points are:
- €Area activity has remained resilient and upside surprises have taken headline HICP inflation to 2.0% for the first time in four years.
- The 2017 ECB inflation forecasts are likely to be revised up from 1.3% to around 1.6-1.8% as they ECB catch up with recent data/market developments. But the more policy-relevant 2018/19 forecasts are less likely to shift up and fading oil price effects mean that we’re probably close to a near-term peak (see Chart below).
- Most Governing Council members should continue to place most weight on subdued core HICP inflation (down to 0.87% y/y in February from 0.92% in January), with the ECB’s relatively-optimistic December forecasts (1.4% in 2018, 1.7% in 2019) probably not being revised up on Thursday.
- Weak wage prospects – driven by the €Area Phillips curve flattening significabtly since 2011, unemployment remaining above the NAIRU, wage rigidities and potential pent-up downward pressure – will probably hold back core inflation.
- Spillovers from stronger (non-oil) global inflationary pressure will likely remain constrained by firms’ limited pricing power (the €A output gap will close only slowly).
- The ECB should learn from it’s persistent over-optimism on wage prospects (see Chart below) and core inflation plus want to avoid repeating their 2008 and 2011 policy mistakes.
- The ECB should want to protect recent limited increases in €Area inflation expectations: further progress is required on both financial market and survey-based measures.
- The ECB’s four criteria for considering tighter policy – inflation rising in the medium-term, not driven by transient factors, not reliant on ECB support and broad-based across countries – probably won’t be met until the Autumn or later.
- Dropping their forward guidance about potential future rate cuts after signalling the need for a ‘steady hand’ to provide stability and predictability in January would represent an unhelpful hawkish signal and raises substantive questions about ECB strategy.
- The ECB will want to maintain an implicit backstop against the impact of political tensions on €Area yields (which I anticipated last November) until the election season ends in the Autumn, even if OAT-Bund spreads are off their peaks.
- Overall the risks seem slightly skewed to a further QE extension being announced in the Autumn, albeit probably involving tapering.
Recent better €Area activity and inflation but core inflation remains subdued
The positive news is that €Area activity data have remained resilient in recent months. The 0.4% q/q Q4 GDP growth matched the Q3 performance as growth was again supported by consumption while fixed investment rebounding from Q3 weakness (see Chart below), although net exports disappointed despite the euro’s depreciation. Moreover, the rise in the €Area composite to a 70-month high in February suggests Q1 growth of around 0.6% (see second Chart). And it’s notable that the PMI uptick has been broad-based across the main €Area countries (even Italy has joined in!) and has been featured elevated new business and employment balances.
Alongside that, €Area headline HICP rose to 2.0% in February, thereby meeting the ECB’s goal for the first time in four years and exceeding the December ECB staff forecast of only 1.3% in Q1. Importanly, however, that’s been driven by two transitory factors as core inflation has remained subdued: (i) upside susprise to food inflation, driven by poor southern European weather raising non-processed food prices; and (ii) oil prices spiking by more than 20% in euro terms since the December ECB forecasts following the OPEC agreement and euro depreciation, with the impact amplified by base effects peaking. And neither (i) nor (ii) seem likely to extend – e.g. the structural factor of potential extra US shale oil production constrains further oil price rises – so subdued core inflation is more likely to act as an attractor for headline inflation rather than the reverse.
Indeed, the second chart above illustrates that if oil prices and the euro remain stable the positive impact of oil prices on headline inflation will retrace sharply over the coming months as oil price inflation falls from nearly 60% y/y in February to around 15% by mid-year as the recent positive base effects wash out. So we may have already seen the peak in headline €Area inflation.
It’s also notable that €Area core goods HICP inflation retaced to only 0.2% y/y in February (see Chart above). That slightly reduces the concerns that higher global inflationary pressures could put upward pressure on €Area inflation e.g. Chinese producer price inflation rising to 6.9% y/y in January (see Chart below). ECB research by Bobeica and Jarociński (2016) finds that international factors explain recent low €Area inflation (whereas low inflation in 2012-14 reflected domestic shocks).
That said, there’s some evidence of €Area producers’ (and retailers’) margins being recently squeezed as they’ve been unable to pass on higher international prices: (i) €A import price inflation of 6.1% y/y in January (it’s highest since late 2011) exceeds the 3.6% y/y €A producer price inflation (see chart above), which in turn exceeds HICP inflation; (ii) the latest €A PMIs report input price balances are significantly more elevated that output price balances, although both are at multi-month highs (see chart above). And €Area producers/retailers could enjoy increased pricing power if €A growth continues. But such upward inflationary pressure will probably be limited given that growth is likely to remain moderate and hence not quickly close the €Area output gap (up to 6% of GDP, see labour market section below).
And the most important point is that core HICP inflation has continued to show no signs of life in recent months – indeed it edged down marginally to 0.87% y/y in February from 0.92% in January. And Governing Council members have been very clear that ECB policy is currently focussed on core inflation, moving away from their unfortunate historic tendency to pay excessive attention to (volatile) headline HICP inflation. For example, the January ECB minutes reported GC members “widely” sharing the view that “it was imperative to maintain a very substantial degree of monetary accommodation.”
2017 ECB inflation forecasts to be revised up, but core inflation to be little changed
The ECB seems certain to raise their 2017 inflation forecasts, given several mechanical factors that have cocurred since December: (i) headline HICP inflation of 2.0% in February exceeds the December ECB staff forecast of 1.3% in Q1; (ii) activity data have remained resilient, with the PMIs suggesting limited strengthening of growth; (iii) oil prices are 20% higher in euro terms as both Brent crude has risen on OPEC supply restrictions and the euro has depreciated; (iv) global inflation shows more signs of improving (see above). So Bundesbank president Weidmann’s recent comment that “inflation this year is likely to be well in excess of the figure projected to date” is unsurprising. But the upward revision from the December forecast of 1.3% inflation in 2017 seems more likely to be 0.2-0.4pp than the 0.5pp Weidmann mentioned. And this is only the ECB catching up with well-known developments: the current market consensus is for 1.5% HICP inflation in 2017.
But, imporantly, the more policy-relevant 2018 and 2019 headline inflation forecasts (1.5% and 1.7% respectively in December) will likely be revised up by substantially less, if at all (there may be some limited spillovers if the ECB wants to put through a more parallel shift in the profile). But the ECB’s core HICP inflation forecasts (1.1%, 1.4% and 1.7% in 2017, 2018 and 2019 respectively) seem unlikely to be revised up much if at all. As discussed above, all the ‘news’ since December relates to temporary factors while core HICP inflation has remained subdued (edged down marginally in February).
Premature to send hawkish signal by dropping option of potential further rate cuts
Neverthless, the combination of resilient activty data and spike in headline HICP inflation shows signs of reigniting divisions within the Governing Council, leading to growing market/media discussions of the ECB possibly making the more hawkish move of watering down it’s forward guidance. This currently has both interest rate and QE elements:
(i) “[The Governing Council] expects interest rates to remain at present or lower levels for an extended period of time, and well past the horizon of our net asset purchases“;
(ii)”asset purchases are intended to continue at a monthly pace of €60 billion until the end of December 2017, or beyond, if necessary, …until the Governing Council sees a sustained adjustment in the path of inflation consistent with its inflation aim”
But Yves Mersch and recently signalled his preference for dropping the guidence on potential further rate cuts (there should be “no delay in making the necessary, gradual adjustments to our communication”) and Bundesbank President Weidmann questioned whether the Governing Council “shouldn’t make its communication more symmetrical“.
Such a language change on Thursday would probably represent a policy mistake, risks repeating the damaging impacts of the abortive 2008 and 2011 ECB rate rises. Overall there has been decent progress, but the situation remains somewhat fragile. And the risk is that markets could take it as a strong hawkish signal that early tapering is in prospect and that Draghi’s dovish approach has less Governing Council backing than hitherto thought.
So it could provoke an inappropriate tightening of financial conditions – rise in goverment bond yields (with real rates potentially rising more than nominal if inflation expectations fall), wider corporate spreads, euro appreciation and possible equity price falls (although as always international factores ). And it would probably unhelpfully damange ECB credibility, given the considerable effort it has exerted in explaining the new focus on core inflation. Indeed, the January ECB minutes reported that “The Governing Council was seen as well advised to remain patient and maintain a ‘steady hand’ to provide stability and predictability in an environment still characterised by a high level of uncertainty“. Changing tack only a few weeks later and without any real evidence of a sustained rise in inflation would raise substantive questions about ECB strategy.
Draghi’s four criteria for tighter policy won’t be met until the Autumn or later
Indeed, the overarching reason for the ECB to maintain their dovish stance on Thursday is that the four criteria for the ECB to start thinking about a change in their policy stance, outlined by Draghi in January, seem unlikely to be until the Autumn at the earliest. The four criteria are that inflation needs to be: (a) near its goal “in the medium term”; (b) durable, not transient; (c) self sustained; and (d) broad based across €Area members. Those criteria have overlaps, are somewhat opaque and are subject to ECB interpretation. But the main points are:
- Criteria (a) amounts to the medium term ECB staff inflation forecasts lying close to 2%. As discussed above, the longer-term December ECB inflation forecasts (peaking at 1.7% in 2019) seem unlikely to be revised up on Thursday. But they could be closer to the ECB objective by the September forecast update or, should €A growth and headline HICP inflation not retrace near term as I expect, in June.
- Criteria (b) reinforces the ECB focus on core inflation – looking through inflation upticks driven by transitory oil/food impacts – and probably represents the toughest criteria to overcome. The next section argues below that prospective continued weak wage growth – driven by a very flat €Area Phillips curve, unemployment remaining above the NAIRU and wage rigidities – will likely keep core inflation subdued. The record of forecast errors indicates that, if anything, the ECB’s December core inflation forecasts appear optimistic. So an upward revision to the core inflation forecasts seems unlikely before the Autumn, with the risks being skewed to later. An intermediate step could be to focus on the 2018 core inflation forecast, with a figure around 1.6-1.7% probably sufficient to trigger a genuine debate (versus 1.4% in the December forecast).
- Criteria (c) indicates out that the inflation uptick needs to be independent of, rather than reliant on, extraordinary ECB policy. Draghi’s press conference comments imply that ECB measures are boosting the 2019 HICP forecasts by around 0.3pp. And that implies that the published forecasts may well have to be commensurately above the ECB’s “close but below 2%” objective. This is probably the criteria with the greatest room for flexible ECB interpretation and the ECB could yet raise the impact of anticipated further QE purchases.
- Criteria (d) – inflation “defined for the whole of the eurozone”- means that German inflation exceeding target won’t be sufficient to trigger tighter ECB policy. But equally continued low inflation a couple of €A members probably won’t prevent tighening. And core HICP inflation (plus ULC growth) remains relatively dispersed across €Area members (see chart below) – with Germany leading the way and Italy the most important laggard. That said, the threshold fulfulling this criteria will probably be lower than for Criteria (b) – perhaps something 2018 headline (core) inflation being above 1.6% (1.4%) for 80% of €A members. So this could be one of the earliest criteria to be fulfilled (by the Autumn).
Continued weak wage growth will keep (services) core inflation subdued: second round effects unlikely
Wage growth is a key determinant of core HICP inflation, especially for the services sector. So we’re unlikely to see a sustained pick-up in €Area inflation until wage pressure starts growing. Moreover, wage bargaining is a prime channel via which ‘second round’ effects of temporarily-higher inflation generated by oil price and food developments can arise, leading to a pick-up in core inflation. And the ECB is currently closely watching for such second round effects. At the January ECB press conference Draghi argued that “The key question now is what is the extent of second-round effects coming from this higher inflation? We’ll certainly look at that with great attention.” And in early February Benoit Couere reiterated that “monetary policy typically reacts to energy price movements by ‘looking through’ their first-round, direct impact, but remaining vigilant regarding any second-round effects on expectations”
But several pieces of evidence suggests higher wage inflation remains some way off and that second round are unlikely to occur. So the ECB seems likely to remain dovishness rather than thinking about watering down it’s forward guidance on Thursday. Specifically:
- Wage pressures have remained very subdued despite the recent sharp rise in headline €Area HICP inflation: the chart below illustrates that all of the main €Area wage growth measures have been flat to falling in recent months. And what matters for inflation prospects is unit labout cost growth, which retraced in Q3.
- That said, the wage cost picture is diverse across €Area members – the above chart below illustrates that it’s strongest in Germany, Portugal, Netherlands and Austria, but is significantly weaker in Italy, Spain and Belgium. Core HICP inflation is also relatively-widely dispersed across coutries (albeit a little less), renforcing the difficulty in meeting the ECB criteria for starting thinking about tightening discussed above.
- ECB forecasts have been consistently over-optimistic on wage growth in recent years (see first Chart below) driving over-optimism on core inflation (second chart below). And the December ECB staff forecast was again pretty optimistic on wage growth – forecasting compensation per employee rising to 2.4% in 2019, which would be the strongest since 2008.
- That said, the ECB finally seems to be showing signs of internalising their consistent one-side forecast errors which I’ve long stressed (see e.g. my May 2016 post). Specifically, the January ECB minutes noted that “It was highlighted that the largest forecast errors had been on wages and that, despite the positive developments observed in employment, there were still no clear signs of labour market pressures…..the muted wage dynamics had played an important role in the still broadly stable indicators of services price inflation”. Such ECB learning will see them remain dovish.
- The €Area Phillips curve seems to have flattened significatly since 2011, further reducing the chances of a sharp pick-up in wage growth (and hence core inflation). The chart below shows that the coefficient unemployment has recently been around a quarter of it’s pre-2011 level, plus has accounted for only 6% of compensation per employee movements, compared to 69% pre-2011.
- OECD/ECB estimates indicate unemployment won’t fall significantly below the NAIRU for the forseeable future, reducing the chances of ‘tipping point’ effects where wage inflation suddenly takes off. Specifically, the OECD estimates the €Area NAIRU at 8.7% in 2017 i.e. significantly above it’s latest outturn (9.6%) while the ECB only forecasts unemployment rate falling to 9.1% in 2018 (see Chart above). Similarly, the OECD anticaptes the broader €Area output gap closing only slowly over the next couple of years.
- That said, the previously-discussed pockets of higher wage growth and core HICP inflation seem likely to persist – the second chart below – likely generating further tensions within the ECB Governing Council.
- The unemployment “gap” approach may overestimate upward wage pressure: (i) €Area wage rigidities will tend to limit wage increases; and (ii) €Area firms have hoarded labour in recent years, so there may be pent-up downward pressure on wages. And it will likely require output to move above potential to get wages and inflation rising sustainably. Similarly, recent ECB research concluded that the best predictions of €Area inflation were obtained using models implying an output gap of around 6% of GDP i.e much larger than the OECD estimate.
- The January ECB minutes noted that “The recent increases in energy prices had thus far not translated into indirect or second-round effects on broader inflation. This suggested second-round effects would unfold rather slowly.
ECB will want to protect recent encouraging inflation expectations developments
The ECB is crucially aware of the importance of managing inflation expectations, given their impact wage bargaining and price setting: this is a second important channel for potential second round effects. Indeed, the January ECB minutes noted that “recent encouraging developments in inflation expectations and the prospects for a sustained adjustment in inflation towards the Governing Council’s inflation aim could be put at risk” by a premature policy tightening. And several pieces of evidence indicate that there’s a long way to go in achieving the desired inrease in inflation expectations – driving a continuing cautious ECB approach.
- There’s been an encouraging rise in the crucial €Area 5y5y inflation breakeavens over recent months – rising from lows around 1.3% last Autumn to around 1.8% in February. But there are also nascent signs of fragility – they’ve retraced to around 1.7% in recent days alongside a fallback in the US equivalent.
- Survey-based measures of inflation expectations have risen to their highest for several years across consumers, industry, servicves and retail trade in recent months (see Chart above). Indeed, the latter three provide some support for the previously-discussed possibility of greater corporate pricing power. But the important caveat is that such survey inflation expectations remain substantially lower than in 2011-13 there remains a long way to go before the ECB can think about resting on it’s laurels.
- The two charts below illustrate that while inflation expectations have recently risen in most €Area members (Italian consumer inflation expectations are the main exception) the ‘levels’ point also applies across a broad range of member states, including higher inflation countries such as Germany.
- The ECB will be conscious of recent staff research (Ciccarelli and Osbat (2016)) concluding that medium-term inflation expectations had become more sensitive to current inflation/macro news (although long-term ones hadn’t).