In June, the ECB announced it was likely to end its net asset purchase programme in December and that it expected to keep interest rates at their present level ‘at least through the summer of 2019‘ , albeit with a caveat relating to inflation developments remaining in line with the Banks expectation of a steady convergence to target. Some confusion ensued as to when the summer actually ends but the ECB has since indicated it is happy enough with market expectations of a rate rise at the September or October meetings next year.
Any change is more likely to initially involve the ECB’s Deposit rate rather than the Refinancing rate, and the latter is more significant for existing Irish mortgage holders as Tracker rates account for over 40% of the stock of mortgage loans.However, it would then only be a short period of time before a rise in the refinancing rate occurred if the ECB was set to embark on monetary tightening.
Why has the Governing Council decided to signal a probable rate rise? In part because the EA economy performed strongly in the latter part of 2017 and although growth moderated in the first half of this year, to 0.4% per quarter, that is still above what the Bank considers to be potential, which has resulted in further falls in the unemployment rate. The ECB is also more confident that wages are finally responding to the tighter labour market, and as a result expects underlying inflation to pick up steadily , with the ex food and energy measure forecast to average 1.8% in 2020 from 1.1% this year. As such , the Council is more confident of a ‘sustained convergence’ in headline inflation to target.
In fact headline inflation has been above target for the past four months, oscillating between 2% and 2.1%, boosted by higher energy prices. Yet that is also squeezing household incomes ( wage growth was 1.9% in q2) and core inflation ( which excludes food , energy, alcohol and tobacco ) has remained stubbornly at 1.1% or below in recent months, slipping back to 0.9% in September.
The economic outlook also looks less robust than it did. The ECB maintains that the risks to EA growth are balanced but at their September meeting it was noted that a case could be made that the risks had tilted to the downside. Since then , the global outlook certainly seems to have deteriorated amid a backdrop of falling equity markets, rising trade tensions, weaker growth in China, a rising dollar, Brexit uncertainties and Italy’s apparent willingness to breach euro fiscal rules.
Indeed, some of the hard data in the EA has been noticeably weaker over the summer months and the PMIs have also softened, with the latest reading for the EA as a whole dropping to a 2-year low of 52.7 in October, That is consistent with GDP growth of only 0.2% a quarter and it will be interesting to see whether the ECB reiterates its balanced risk view at the upcoming meeting.
It may be that the current weakness in sentiment and activity proves temporary but what may also concern the ECB is that more forward looking indicators also signal weakness ahead. The major European equity indices are all heavily in the red year to date while monetary indicators are not reassuring; M3 growth has slowed to 3.5% while the growth rate of lending to the private sector has remained becalmed at 3.4% in recent months, with mortgage lending slowing a little to 3.2%.
It is unlikely that the ECB will do a volte- face on its forward guidance at this juncture but the risks to their view on inflation have risen and it is not a done deal that rates will rise in 2019.