Stronger euro and weaker oil bad news for ECB hawks

Last December the euro briefly traded below 1.04 against the US dollar and few forecasters envisaged a short term recovery, with a number calling for parity against the greenback. In the event the euro has appreciated, with the past two months seeing a notable rally, taking the single currency above $1.12. The consensus has also shifted, with many abandoning bearish calls in favour of further euro appreciation. Speculative positioning  has also tilted decisively, with the market now running modestly long the euro/dollar for the first time in over three years.

One factor driving the euro is the economic data, which has generally surprised to the upside,  in turn prompting analysts to revise up their GDP projections. As a consequence many now expect the ECB to shift its policy stance, moving initially towards less dovish rhetoric before changing its forward guidance, although a rise in the deposit rate is not fully priced in until the latter part of 2018. In contrast, the US data has tended to surprise to the downside and the market, which was effectively pricing in two further rate hikes in the US this year, is now much less confident about the second ( although  a rise this month is still seen as highly likely)

In its  Staff forecast in March the ECB projected inflation at 1.7% in 2019, predicated on a euro/dollar rate of $1.07 over the forecast horizon. The exchange rate is seen to have a significant impact on prices in the EA and if the next forecast ( due later this week) used a rate of $1.12 that , all else equal, may push the inflation forecast for 2019 down by as much as 0.2 percentage points.

Moreover, the March forecast assumed an oil price around $56 over the next few years, and that now looks too high, given developments of late , with  Brent crude prices falling to around $50 on market concerns that the OPEC cuts have not been sufficient to make an appreciable dent in the unusually high level of crude stocks. Again, a lower oil price projection, say around $50, would shave up to another 0.2 percentage points off the inflation projection.

Of course the Staff may revise up some other components ( wage growth for example) to avoid having to lower the inflation outlook, and one sometimes wonders if the forecast drives ECB policy or the other way round, but on the face of it the combination of weaker oil and a stronger currency should have a disinflationary impact.

 

ECB -where to from here?

The ECB’s mandate is to deliver price stability, which the Bank itself initially defined as an annual inflation rate below 2%. Clearly there was no thought given to the risks of deflation with such an asymmetric target and the definition was subsequently tweaked to the current ‘below but close to 2%’. Euro area inflation fell below 2% in early 2013 and below 1% a year ago, with the latest ECB staff forecast projecting very low inflation for at least another two years. Moreover , the forecast was predicated on oil prices averaging $86 a barrel next year , which now looks high given that Brent is currently trading under $70.

There are ‘long and variable’ time lags with monetary policy, so one could argue that the current low inflation rate (the flash figure for November was 0.3%) reflects policy decisions made some time ago-remember the ECB actually tightened policy in 2011. Against that backdrop the recent press conference by ECB President Draghi was remarkable in many ways, not least because he had promised ‘immediate action’ on inflation in a speech in the latter part of November.

In the event the only change of note was in the language surrounding an expansion of the ECB’s balance sheet, which had been  ‘expected‘ to reach the level seen in early 2012 but now measures are ‘intended’ to achieve that level. That would entail an increase of about €1,000bn and clearly there is no agreement within the ECB to promote that as a target. Indeed, Draghi stated that there was not unanimity among the 6-member Executive Board on the announced change in wording, limited as it was.

Draghi had previously played down disagreements within the Governing Council but here seemed willing to place them out in the open, emphasising at one point that previous decisions had been taken  by majority. The obvious divisions  on further policy action made for an uncomfortable conference, however, with Draghi having to again indicate the need for more time to assess the situation despite more forecast downgrades and the blatant contradiction between that  approach and his earlier promise of ‘immediate action’

The upshot is that the Governing Council will reassess the situation ‘early next year’  including the size of the balance sheet. That will be affected by the existing bond buying programme (albeit the figure to date is just €22.5bn) and the outcome of the second targeted long term loan operation (the TLTRO). The latter saw a low uptake for the first tranche (€82bn) and there is a wide range of expectations with regard to the one upcoming, while there will be some offsetting downward pressure on the balance sheet via repayment of previous long term lending to the banks.

The euro rallied during the conference, which was attributed to disappointment about a  QE announcement, although that remains  the market’s general expectation. For others, including this writer, it remains less than a certainty that the ECB will eventually buy sovereign debt, and if it does it is not at all clear how much of an impact it will have on economic activity and inflation, leaving aside the impact it has already had on asset prices. A lot of uncertainty then, and one wonders if the next few months will see further resignations from the ECB Council given the fundamental disagreements on the next steps for monetary policy.