June ECB Preview: Dovish Tinkering

On Thursday the ECB will likely only tinker around the edges of their commentary and forward guidance (see red entries in table below) – such a dovish press conference will likely generate a small euro depreciation and fall and €Area yields.  Specifically, the ECB will likely: (i) acknowledge the improving growth outlook by moving to describing growth risks as “balanced” (for the first time since 2011); (ii) drop the ‘or lower’ clause from their interest rate forward guidance.  But Draghi’s reiteration of the dovish message that €Area underlying inflation pressures continue to lack a convincing upward trend (core HICP disappointingly retraced to only 0.9% in May), will likely be given added weight by the ECB inflation forecasts being revised down (headline by 0.2-0.3pp, core by 0.1-0.2pp, most likely 2017/18, possibly 2019). That’s because the ECB seems to be catching up with my previous analysis that weak unit labour cost (ULC) growth across all the main €Area members, driven by a flatter Phillips curve, equates to persistently subdued domestically generated inflation.  Moreover, producer pipeline pressures have slowed, survey inflation expectations have retraced and the euro’s appreciation plus lower oil prices indicate weaker inflation prospects.  Overall, the second and third of the four inflation criteria Draghi oulined in January aren’t yet met – inflation hasn’t durably converged to target and remains dependent on ECB policy (not self-sustaining). So market expectations of a more hawkish ECB shift, encouraged by reduced political risks, stronger €Area growth prospects and interpretations of Coeure’s Reuters interview, will likely be disappointed (as they were in April) although they have receded after the weak May HICP data. Rather, Draghi will likely portray the ECB’s small tweaking as just moving the forward guidance in line with improved economic realities and will repeat dovish comments. A dovish market interpretation will be helped by comments indicating flexibility on the capital key, following German purchases undershooting in May.

Slide2That said, ECB history means that it’s not inconceivable that they could also dilute other elements of their stance on Thursday (pink text in table): (a) dropping the ‘well’ from the ‘well past the horizon of asset purchases‘ in the rates guidance; (b) dropping the committment to stand ready to increase the ‘size’ of QE purchases; (c) dropping the need for a ‘very’ substantial degree of monetary policy accommodation.  But there’s a relatively small risks of such hawkish changes given the continued subdued inflation picture and recent Draghi comments. Indeed, on 29 May Draghi seemed to upgrade the forward guidance when he argued that  “We remain firmly convinced that an extraordinary amount of monetary policy support, including through our forward guidance, is still necessary.

(Core) inflation remains weak – April bounce was erratic (as ECB expected) and survey inflation expectations have fallen

As is well-known, €Area inflation retraced more than expected in May (see Chart) – with headline HICP falling to 1.4% (from 1.9% in April) and, more importantly, core HICP falling to only 0.9% (from 1.2%).  So there’s likely a disappointing start-point to the ECB forecasts (disappointingly they don’t publish quarterly forecasts). The April spike was, as suspected, indeed driven by the different timing of Easter this year (plus energy factors).  And it’s notable than non-energy goods inflation remained at a low 0.3% while services inflation fell back to only 1.3% (from 1.8%, due to the impact on package holiday prices).


This May €Area core inflation disappointment seems highly likely to be matched in the country-level data (the published country headline HICP mirrored the €Area aggregate). But it’s notable that French core inflation has been significantly weaker than the other main €Area countries (only 0.6% in April, versus 1.6% in Germany), encouraging continued ECB dovishness.

Importantly, ECB speakers have also been relatively-unanimous that underlying pressures remain weak and reliant on monetary policy support. And that list includes even the Bundesbank’s Lautenschläger – who acknowledged that loose ECB policy is appropriate and called for a patient approach to changing forward guidance:

  • “What counts most now is underlying inflation, for example core inflation. And that’s still on the weak side.” (Praet, 11 May)
  • underlying inflation pressures still give scant indications of a convincing upward trend as domestic cost pressures, notably wage growth, remain subdued … the outlook for price stability remains conditional on the very substantial degree of monetary accommodation… Without this support, the progress towards a sustained adjustment … will likely be slower or even stall.”
  • “…we cannot yet be sure that the upturn in inflation is sustainable and self-sustained, that it will be there without our monetary policy support.” (Coeuré, 18 May)
  •  “measures of underlying inflation remained subdued, with unutilised resources still weighing on domestic wage and price formation” (ECB minutes).
  • “Despite a firmer recovery….underlying inflation pressures have remained subdued. Domestic cost pressures, notably from wages, are still insufficient to support a durable and self-sustaining convergence of inflation toward our medium-term objective.” (Draghi, 29 May)
  • “Domestic price pressures are still subdued; the same is true for wages…current inflation still contains an element of monetary policy” (Lautenschläger, 31 May)

What’s been less widely commented on is that some survey inflation expectations have recently weakened. Specifically, the European commission inflation expectations for industry, services, consumers and retailers all retraced in May and remain significantly below their 2011-13 levels (see chart).  Within that: (i) Consumer inflation expectations are significantly below 2011 levels in all the main €A members but they are particularly weak in Italy and Portugal; (ii) Industry inflation expectations are less dispersed across countries, although Germany again unsurprisingly leads the pack; (iii) Services inflation expectations are the most widely dispersed across countries – with France lagging and Germany leading by a significant margin.

Similarly, the composite PMI price pressure sub-component also recently retraced (as both input price and output price balances fell) and remains below it’s 2011-12 levels (see Chart).  Finally, market 5y5y inflation breakevens also remain subdued, although the ECB seems to have downweighted these (conveniently ascribing their moves the risk premia fluctuations).


ECB catching up with my analysis of weak wage growth, but other pipeline inflation pressures also risk stalling

The ECB has increasingly been focussing on the key issue of whether €Area domestically generated inflation will rise to take over the batton of waning inflationary support from previous commodity price rises and Euro depreciation.  That’s mainly because the ECB has been catching up with my previous analysis that weak unit labour cost (ULC) growth across all the main €Area members means that domestically generated inflation will remain oersistently subdued.

The facts are straightforward: while there have been some limited rises in compensation for employee growth what matters for inflation is unit labour cost (ULC) growth and that has recently been uniformly weak in the main €Area countries.  Indeed, ULC growth has fallen in most of the main €Area countries over the past six months, with Germany reporting the highest rate of a paltry 0.9% y/y in Q1 (down from 2.0% in Q3).  The only exception was Spain, but that was a case of ULC growth becomming marginally less negative.


My previous analysis made several important points, arguing that weak ULC growth was likely to continue holding back inflation:

  • ECB forecasts have been consistently over-optimistic on wage growth in recent years , which had driven the over-optimism on core inflation. But the February ECB minutes suggested that they were beginning to internalise these persistent forecasting errors.

    • The surprising upward revision to the ECB ULC forecast in March (see Chart above), which occurred despite compensation per employee forecasts being unchanged, is therefore ripe to be reversed.   
  • The €Area Phillips curve seems to have flattened significatly since 2011, with the unemployment coefficient recently only being around a quarter of it’s pre-2011 level and with condiderably lower explanatory power for wage growth.
  • 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.   The June OECD outlook estimates the €Area NAIRU at 8.8% in 2017 (8.6% in 2018), significantly above it’s latest outturn (9.3% although that was better than expected). And in March the ECB only forecast the unemployment rate falling to 8.9% in 2018.

The April ECB minutes signialled that the ECB were starting to catch up with this weak wage growth argument: they reported the GC questioning the susprisingly-strong ULC growth assumption in their March forecast and hinting at potential changes to the analytical approach in a more dovish direction. 

  • measures of underlying inflation remained subdued, with unutilised resources still weighing on domestic wage and price formation”.
  • it was recalled that the March 2017 ECB staff projections foresaw a relatively steep pick-up in wages. So far, however, there had not been any significant increase in wage growth, despite the declining output gap and lower unemployment rates. It was considered that the role of wider measures of slack could be explored further, while, more generally, it was felt that a more in-depth investigation of wage behaviour was needed, including wage settlements and bargaining processes, as well as changes in income distribution. It was conjectured that structural changes in wage dynamics in Europe might be at play, with possible implications for long-term changes in the dynamics of underlying inflation.
    • I’m sympathtic to the idea that structural changes in the wage formation process are at play.  But I’d stress that this is an international development – I’ve previously argued that the UK and US Phillips curves have also flattened.
  • the strong pick-up in wage growth assumed in the March 2017 projection baseline was uncertain.”

And in April Draghi argued that continued weak wage growth reflected continued large labour market slack and previous low inflation on reducing nominal wage demands (since low HICP inflation boosts real wage growth) and that the ECB needed to see clear evidence that underutilised resources are declining and then generating higher wage pressure.  On 24 May Praet argued that the main question facing the Governing Council is “to what extent with the closing of this output gap, you see the pass-through into wages at some point“.  And more recently Coeure argued that hysteresis effects mean that €Area economic slack is higher than implied by (still high) unemployment rates.

On top of such weak weak wage cost pressures there are also nascent signs of waning producer price inflation i.e. pipeline inflation pressures.  Specifically, the chart below illustrates that 3m/3m producer price inflation has recently fallen, to lie signifucantly below the y/y equivalents.


ECB Inflation forecasts to likely be revised down (headline HICP by 0.2-0.3pp, core HICP by 0.1-0.2pp): € appreciation and oil price fall on top of weaker ULC prospects

This evidence of weaker domestically generated inflation and pipeline inflation pressures seems likely to translate into downward revisions to the ECB’s inflation forecasts.  So the surprising upward revision to the ECB core HICP forecast in March (see Chart), such that it exceeding the headline HICP forecast at the 3-year horizon (1.8% vs 1.7%) for the first time since September 2014, also seems ripe for a small downward revision.  And the April ECB minutes highlighted that “a downward revision to the inflation outlook in the June 2017 Eurosystem staff macroeconomic projections could not be ruled out.”


That downward pressure on the inflation forecasts will be reinforced by the recent euro appreciation plus lower oil prices. Specifically, between the March annd June forecast cutof dates the €/$ exchange rate rose by 2.3 while oil prices fell 13.4% (based upon the two-week averages used by the ECB).  These financial market moves should knock around 0.1pp off the 2017 and 2018 inflation forecasts.  And the previously-discussed weaker domestically generated inflation pressures seem likely to have a similar, if not larger, impact depending on the extent of the ECB’s labour market rethink (they tend to move slowly). So the ECB headline HICP forecasts should fall by 0.2-0.3pp in 2017 and 2018, but less in 2019.  And smaller cuts should be expected for the core HICP forecasts (0.1-0.2pp). 

The further 2.5% €/$ rise since the May 16th cutoff for the June forecast will also likely reinforce Draghi’s incentive to come across as dovish in the press conference.

ECB to marginally soften rates forward guidance: ‘or lower’ clause dropped, but remaining forward guidance unchanged by cautious ECB (policy sequencing unchanged)

Given this, the description of inflation and of inflation prospects in the opening statement seem pretty certain to remain unchanged.

  • ‘underlying inflation pressures continue to remain subdued and have yet to show a convincing upward trend.’
  • ‘…as unutilised resources are still weighing on domestic wage and price formation, measures of underlying inflation remain low and are expected to rise only gradually over the medium term’

And given the previously-described cumulative progress on growth, but little progress on inflation, there will likely only be small tinkering changes to the ECB forward guidance on Thursday.

Specifically, only the reference to “or lower” interest rate forward guidance in the ECB opening statament is likely to be dropped on Thursday.  Draghi laid the foundations in March when he argued that removing the “or lower” clause was not a “big decision”.  And Benoit Coeure reinforced the argumenent in his Reuters interview: “Too much gradualism in monetary policy [communication] bears the risk of larger market adjustments when the decision is eventually taken…It’s the risk that our communication deviates from economic reality, which could cause a more forceful market adjustment down the road“.  So the small tinkering will be presented as just moving the forward guidance in line with improved economic realities.   

But the April ECB minutes also revealed that the consensus on the Governing Council is to proceed cautiously in changing the forward guidance: “should be adjusted in a very gradual and cautious manner as, at the current juncture, monetary and financial conditions were particularly sensitive to changes.” In other words they don’t want to cause a taper tantrum which would generate an inappropriate tightening of financial conditions (euro appreciation, yield curve rise, equity price fall). And they seem to have learnt the lessons from their 2008 and 2011 policy mistakes.  This ECB caution, combined with downward revisions to the (core) inflation forecasts (see above), means that it’s unlikely that they will change the other elements of their forward guidance.   

Of course the risk of further changes can’t be completely ruled out given the improved growth environment and the ECB’s likely desire to get to a situation of being able to announce a QE tapering by end-year at the latest and more probably by September (to fit in with the ECB pattern of announcing QE changes three months prior to the end of the programme).

And probably the next most likely change would be to dilute their commitment to maintain low rates “well past the horizon of our net asset purchases” to only “past the horizon…” i.e. drop the “well” clause.  But even in the unlikely event of that happening on Thursday Draghi would likely reiterate that the policy sequencing plan (i.e. rate rises only coming after QE has ended, rather than during the tapering period) is unchanged despite Coeure’s recent concerns about the impact of negative rates on bank’s net interest rate margins (see the Chart below from Angeloni (2017), which is a little more negative than previous estimates).

  • Draghi has recently been firm on the sequencing point (although he unhelpfully opened the door to possibility of early rate rises in March). Indeed he recently argued that “there is no reason to deviate from the indications we have been consistently providing in the introductory statement” . 
  • Draghi further argued that asset purchases were “more likely to produce side-effects than….moderately negative rates”.  The corollary is that tapering will raise banks’ margins by generating a steepening of the yield curve (but they only want this to happen when core inflation shows signs of life).
  • While Coeure recently argued that a one-off rate hike would offset the adverse impact on banks’ margins, thereby improving the transmission of loose monetary policy, he was arguing about that as a future, not current, issue.
  • Unexpectedly changing the policy sequencing would needlessly damage ECB policy credibility.       


It’s also unlikely that the ECB will change the guidance that ‘If the outlook becomes less favourable, or if financial conditions become inconsistent with further progress towards a sustained adjustment in the path of inflation, we stand ready to increase our asset purchase programme in terms of size and/or duration.’  But there is risk that the “size” clause will be dropped on Thursday, given that few (any?) GC members now genuinely think that there’s a scenario where they would move back to over €60bn a month of purchases.  And that would set the ground for a September tapering announcement.  But my judgement is that the continued weak inflation prospects will keep the hawks at bay.

Similarly, the April overall summary that ‘A very substantial degree of monetary accommodation is still needed for underlying inflation pressures to build up and support headline inflation in the medium term.’ also seems unlikely to change.  While there has been some market commentary that “very” could be dropped on 29 May Draghi seemed to argue for an even more dovish language when he stated that “We remain firmly convinced that an extraordinary amount of monetary policy support, including through our forward guidance, is still necessary.

ECB to acknowledge improved growth outlook: ‘balanced’ growth risks for first time since 2011

The improvement in €Area growth prospects has several well-known elements which the market has been increasingly recognising (helping euro appreciation). Collectively they should be sufficient for the ECB to update its April description of growth risks from ‘The risks surrounding the euro area growth outlook, while moving towards a more balanced configuration, are still tilted to the downside and relate predominantly to global factors.’ to a phrase signalling balanced growth risks:

  • €Area growth of 0.5% q/q in Q1 was the sixteen consecutive quarter of OK growth which has: (i) become more driven by domestic demand (and so should be more resilient); and (ii) become more broad-based across members – indeed, recent upward revisions to individual country data mean that €Area Q1 GDP could be revised up to 0.6% on Thursday.
  • The €Area composite PMI hit a six-year high in May (suggesting 0.7% Q2 GDP growth), with notably low dispersion across the main countries (see Chart).  Germany leads the pack in manufacturing, with the IFO hitting it’s highest-ever level (see Chart) whereas Spain and France lead the way in services.
  • Continued slow improvements in €Area credit dynamics – loans to non-financial companies and to households both rose 2.4% y/y in April, up around 5pp from their lows a couple of years but still hardly booming (although there is evidence of €Area firms increasingly using market-based finance).
  • Near-term global risks seem to have dissipated (although longer-term risks such as Trump-driven protectionism and China debt can’t be completely dismissed): the composite Global PMI has risen/steadied (although the €Area actually leads the pack) and global export/import/industrial production growth has picked up (although momentum slowed slightly in the latest data).




This would be the first time since August 2011 that €Area growth risks are charecterised as balanced, and the first time under Draghi.  The ECB prepared the way in April by dropping one of the two references to downside growth risks from the opening statement.  And ECB speakers have given a consistent message in recent weeks that downside risks have diminished:

  • ECB is “within reach” of describing risks to the recovery as “broadly balanced” (Mersch, 8 May)
  • “When you look back at soft and hard data that we’ve had over the last weeks and months, it gives a much, much better picture than the one  we had, say, one year ago. It’s a job-rich recovery and it’s much broader both across sectors and across economies. (Coeuré, 13 May)
  • “The upswing is becoming increasingly solid, and continues to broaden across sectors and countries” (Praet, 24 May)
  • “Downside risks to the growth outlook are further diminishing, and some of the tail risks we were facing at the end of last year have receded measurably.” (Draghi, 29 May)
  • “The recovery continues to firm and broaden, while the risks to growth are now balanced” (Lautenschläger, 31 May)

There are, however, some caveats which should mean that the ECB doesn’t get carried away on a wave of optimism (in addition to those noted above).  The main one is that the strong €Area survey data have yet to be reflected in the “hard” official data data.  Indeed, industrial production momentum has recently slowed in all the main €Area countries except Germany (see Chart) and €Area retail sales were subdued in April (see Chart).  So the ECB is still taking an (understandable) leap of faith, given the mixed forecasting performance of PMI data, that the hard data will pick up even if strong employment growth should support consumption (with some constraint from weak wage growth). But it’s also not a complete no-brainer on the surveys: (i) the forward-looking component of the IFO survey is not particularly elevated (see Chart above) i.e. the recent record levels reflect current conditions; (ii) the European Commission economic sentiment indicator  edged down in May on weaker services, although it remains elevated.



Market impact probably small: dovish surprise could stall recent euro strength and be bullish €A bonds

Market expectations of the ECB diluting it’s dovish policy guidance on Thursday is one of the factors supporting the euro’s recent rise (€/$ up from 1.06 in mid-April to approaching 1.13 recently, with CFTC-reported short euro positions being liquidated and the downside skew in €/$ risk reversals disappearing). So a moderately dovish ECB on Thursday, especially if the 2019 core inflation forecast is revised down, would be expected to put a small dent in that recent € strength as well as generating a fall in €Area yields. A dovish market interpretation will be helped by comments indicating flexibility on the capital key, following German purchases undershooting in May.

But it’s important not to forget that other factors also appear to have supported the euro, and could well continue to do so in the coming months.  These factors include:
(i) Reduced €Area political risk after Macron’s win (and limited risks associated with the prospective early Italian election, given the change in the voting system) allied to the White House’s recent woes;
(ii) Market participants juding the € undervalued – driven by it remaining below historic and benefitting from a 3% of GDP current account surplus. The Peterson Institute recently estimated the €/$ FEER at 1.13 i.e only marginally above recent levels (although FEERs are weak near-term attractors);
(iii) Portfolio managers reportedly correcting underweight positions in Eurozone equities (European markets have outperformed US stocks);
(iv) Reserve managers also correcting their underweight positions:  the €’s share of global reserves has fallen to 20% from 28% in 2009.

And, of course, ECB tapering will likely come more into focus over the coming months, thereby supporting the €, although there will also likely be further Fed hikes over this period (likely starting 14 June!).



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