ECB’s Outlook for economic growth still balanced

The ECB Governing Council left its policy stance and communication broadly unchanged at the October meeting. The Governing Council maintained its view that risks surrounding its outlook for the Euro area economy were broadly balanced. The Introductory Statement noted that data since the previous meeting had been somewhat weaker-than-expected, but nonetheless concluded that, overall, recent data remain consistent with an ongoing broad expansion in the Euro area. Some part of the data weakness was seen as transitory, reflecting temporary idiosyncratic developments. High capacity utilisation constraining the ability to expand more quickly was also offered as an explanation of recent weakness. The Introductory Statement listed market volatility, EM growth and protectionism as key risks to growth. Notwithstanding this recognition of recent weakness, in our view the policy agenda set out by the Governing Council in June remains intact at this stage, with incoming data over the next few months determining whether the ECB will need to deviate from that plan. Otherwise, Mr. Draghi reported that policy changes were not discussed at today’s meeting, while reiterating that the APP is expected to cease by year-end. On Italy, Mr. Draghi noted the negative impact of market tension and higher rates on Italian growth, but argued that the spill-over from recent financial market developments otherwise does not seem significant as yet. Today’s ECB communication was broadly in line with our expectations and we maintain our base case forecast that the APP will cease by end-year and the first hike of policy rates will come in Q4 2019. We see the distribution of outcomes as bi-modal. Should recent data weakness persist or become more profound, we would shift to our downside risk scenario, which foresees a postponement of the first rate hike to sometime in 2020 and a possible downward revision to the signalled pace of subsequent hikes . Our highlight is below:

1. The Introductory Statement showed that the ECB maintains its base case for economic growth. The current economic expansion is still viewed by the Governing Council as ongoing and broad-based. The Introductory Statement added that this is despite incoming information being “somewhat weaker than expected”. The economic expansion is “supported by domestic demand and continued improvements in the labour market”. The Introductory Statement said that some “sector-specific developments are having an impact on the near-term growth profile”. Mr. Draghi further added that the weakness in activity data was related to idiosyncratic factors in specific countries (such as the re-tooling of the auto industry in Germany), uncertainty related to trade, weakness in EM growth and financial market volatility, as well as a constraining effect from current high levels of capacity utilisation. He noted that some of these factors are transitory, some are trend-like; some are specific to countries and some are broader. Mr. Draghi noted that the recent unexpected weakness was not, as yet, sufficient reason to change the overall assessment of the balance of risks surrounding the outlook. A broader assessment will take place in the context of the updated staff macroeconomic projections in December.

2. On inflation, the Introductory Statement was broadly unchanged from September, stating that “while measures of underlying inflation remain generally muted, they have been increasing from earlier lows” and “domestic cost pressures are strengthening amid high levels of capacity utilisation and tightening labour markets”. Underlying inflation is still expected to increase “further” – a change from “gradually” – over the medium term supported by the ECB’s monetary policy measures. Mr. Draghi again highlighted rising nominal wages, including negotiated wages as an input into the inflation assessment.

3. Mr. Draghi received some questions on Italy, as expected. Here Mr. Draghi noted that higher interest rates and market tensions weighed on Italian growth prospects and that this, in turn, reduced Italy’s fiscal space. Mr. Draghi generally referred the more political questions on Italian fiscal policy to the European Commission, which he emphasised was the responsible institution for assessing Italy’s fiscal outlook. Mr. Draghi did express a personal view, stating that he is confident that a agreement between Italy and the European Commission will be found.

4. As announced at the June meeting, net asset purchases under the APP are currently running at EUR15bn per month and are on course to cease by year-end. While stating that changes to the outlook for the APP from this baseline had not been discussed at today’s meeting, Mr. Draghi gave no impression that the Governing Council will deviate from this plan. No further details on reinvestments of the APP were given at today’s meeting. Mr. Draghi indicated that some discussion was due at the December meeting, but again said that this had not been discussed today. He re-affirmed that he would be surprised if the Governing Council chose to deviate from the principle of using the ECB’s capital key to govern the distribution of ECB sovereign asset holdings across issuers. We expect the ECB to retain the current broad principles of capital key and ‘market neutrality’, albeit while also maintaining a high degree of flexibility in the implementation of the reinvestment programme from next year.

5. The forward rate guidance remains unchanged. The Introductory Statement reaffirms – in its ‘date dependent’ guidance – that the ECB expects policy rates to remain at their current levels “at least through the summer of 2019”. The current guidance still offers flexibility in terms of what will happen after the summer next year – the Governing Council maintains a ‘state dependent’ rate guidance (in addition to the date guidance) indicating that rates will be on hold for as long as necessary to ensure the continued sustained convergence of inflation. We see changes to the forward guidance as the first tool to which the Governing Council would resort if they saw the need to change the broader policy stance. Mr. Draghi noted, in answering questions on easing options, that the ECB has tools available, but that their ranking or relevance at present had not been discussed at today’s meeting. Mr. Draghi said that two Governing Council members had raised the possibility of further T-LTRO tenders.

Our view remains unchanged following  press conference. We expect net purchases under the APP to cease by end-year. The bar for deviating from the Governing Council’s guidance on the pace and end-date of the APP seems high. We expect the first rate hike to come in Q4 2019, for example at the October meeting. We expect the first hike to be 20bp. Once the ECB starts to hike, we expect an annual pace of hikes of around 40bp. While today’s ECB announcement does little directly to change the outlook, we continue to see risk skewed to the downside. We see the distribution of policy paths as bi-modal from here. The downside risk has risen as of late with escalating issues related to Italy and some weak survey data. Should growth momentum fall sufficiently and reduce the inflation outlook materially, we would expect the ECB to use forward rate guidance to push out expectations of its first policy rate hike by some quarters; it could also communicate that a slower pace of hikes than currently envisaged by the market is appropriate in this scenario. The incoming activity data ahead of the December and March ECB staff macroeconomic projections will be the key input as to whether we shift from our main scenario to a downside scenario.