ECB — Ending net asset purchases on a dovish tone

The ECB will announce its policy decisions next week, on December 13 at 12:45pm (GMT). President Draghi’s press conference will follow at 1:30pm (London time). Updated ECB staff macro-economic projections will be published, with 2021 added to the forecast horizon. The account of the December meeting is likely to be published on 10 January.

In short, we expect the ECB’s Governing Council meeting in December to (1) confirm that net asset purchases are ending by year-end; (2) apply a dovish tone, by recognising rising downside risk and weak Q3 data (even if the ECB can look through this idiosyncratic dip), but stop short of downgrading the risk assessment from balanced to downside; (3) maintain its overall base case as laid out at the June Governing Council meeting; this scenario remains the single most likely path. But the probability of this scenario materialising has gone down in recent weeks, and we expect Mr. Draghi to give some indication of this.

We expect the following from next week’s Governing Council meeting:

  • Announcements on net asset purchases. We expect the ECB to follow though on its guidance and announce an end to net asset purchases. This should be no surprise and should be more or less fully anticipated by the market. The ECB has little scope to continue net asset purchases if it is to satisfy its 33% issuer/issue constraint. It has signalled clearly that it intends to end net asset purchases by year-end on the back of signs of rising underlying price pressures. The developments in wage growth should be sufficient to allow the ECB to go ahead with its plan to end net asset purchases.
  • Details on reinvestments once net asset purchases end. The current guidance is valid only while net asset purchases take place. With the end of purchases coming approaching, an update is due. We expect the ECB to maintain its broad principles. This includes the capital key as the guide. It also includes maintaining the 33% issue/issuer limit. The ECB’s principle of ‘neutrality’ implies that its purchases in terms of maturity match the outstanding market maturity. We expect this principle to continue. A ‘twist’, whereby the ECB announces purchases of longer-maturity bonds than it currently holds seems unlikely to us. The practical issues related to this are large given current constraints. We expect the ECB to allow itself a large degree of operational flexibility but aim to maintain a bond portfolio that matches the capital key and average outstanding market maturity. Having flexibility implies that there can be sizeable temporary deviations from the aims at times.
  • Staff macroeconomic projections of GDP growth and the Governing Council’s view on the economic outlook. There will be significant focus on the tone of the economic outlook in the Introductory Statement and press conference. We expect the ECB staff macroeconomic projections to show a small downward revision to GDP growth for 2018 and 2019 (-0.1pp for both years; Exhibit 1). This reflects a weaker Q3 out-turn and some general signs of slower growth from abroad and in places with little or no remaining spare capacity. Lower oil prices should boost GDP growth in 2019 and 2020. The October account and recent speeches by President Draghi at the ECB Banking Conference and last week’s speech at the European Parliament, as well as a speech by Executive Board member Praet suggest that the main scenario  is still on track. The account of the October ECB meeting notes that the slowdown in growth relative to 2017 mainly reflects weaker net exports and temporary idiosyncratic factors. It also reflects that spare capacity has been reduced. The Composite PMI was 52.7 at the October meeting and the account of the Governing Council meeting seemed to indicate that this was not at odds with its base-line assessment of underlying growth. The Composite PMI fell in November, but from an upwardly revised figure. It now stands at 52.4, close to the level going into the October meeting. The account of the October Governing Council meeting highlighted robust consumer confidence. Despite the November fall, consumer confidence remains well above its historical average. This allows the ECB to maintain its overall story that domestic demand is robust, employment is rising, unemployment is falling, wage growth is moving higher and thus household incomes are increasing. All of this underpins robust consumption, which further boosts employment, and so on.
  • The Governing Council’s risk assessment of the economic outlook. The risk assessment of the main scenario will also be re-assessed by the Governing Council. It has previously indicated that downside risks related to external factors have risen while domestic factors imply that it still sees the risks around the economic outlook as balanced. The external risks are related to protectionism and its effect on trade and confidence; financial market volatility; and EM vulnerability. Risks related to a disorderly Brexit have also noted. Since October, these risks to not seem to have become greater, even if the modal scenario for growth seems slightly weaker.
  • Inflation assessment and updated staff inflation forecast. Mr. Draghi summed up the ECB view at his recent speech at the European Parliament saying: “generally, there is good reason to be confident that underlying inflation will gradually rise in the period ahead. Wages are rising as labour markets continue to improve and labour supply shortages become increasingly binding in some countries. Higher wage growth, as well as a recovery in producer and import prices, is expected to continue to support the upward adjustment in underlying inflation. In addition, long-term market and survey-based inflation expectations are reasonably well anchored and broadly in line with this outlook.” We think Mr. Draghi will repeat this assessment in December. Wage growth is on track with the ECB staff forecast. In terms of forecast changes, lower oil prices should lower the headline inflation forecast for next year. We expect little change to the core inflation forecast. We think the ECB will forecast 2021 inflation at +1.9%.
  • T-LTRO discussion. We expect, as in October, that Mr. Draghi will hint that there has been some discussion about extending the T-LTROs. But we do not expect Mr. Draghi to give further details or make any further hints. The Governing Council is still likely to see a decision on T-LTROs as premature, although we think an extension is due some time in the first half of next year. We see the T-LTRO discussion as mainly motivated by developments in Italy. As we have recently argued, T-LTROs are powerful funding tools when needed as funding dries up.

We expect the overall monetary policy message to be that the June base case is in place but risks are present and the probability of the June base case has gone down. We expect Mr. Draghi to note the need for patience and prudence and, overall, attempt to communicate a dovish tone while still ending net asset purchases. While confirming the end of net asset purchases, we expect Mr. Draghi to emphasise next week that the Governing Council is monitoring incoming data and that the ECB’s rate path is state- dependent, implying that the ECB will, if necessary, respond to weaker inflation prospects by adjusting its forward guidance.