Saturday 25 January 2020

Daily Market Update: ECB in wait and see mode, but retains a clear bias to do more if needed

ECB Headquarters
ECB Headquarters

Simon Barrry

There was little surprise at yesterday’s ECB decision to leave its monetary policy stance unchanged – an outcome that was fully in line with market expectations.

There wasn’t much to get excited about in the post-meeting press conference either which largely re-iterated the ECB’s main policy messages. The ECB is reasonably encouraged by the ongoing improvement in overall financing conditions in the zone which Draghi argued has been underpinned by the ECB’s policy stimulus measures, including the comprehensive package of new measures adopted last month. This, in turn, along with low oil prices and improved labour market and corporate profitability trends, should support the outlook for consumption and investment spending in the zone, thus keeping the domestic demand-led recovery on track.

Euro Growth?

Draghi indicated that Q1 GDP growth looks to be headed for a similar outturn to the 0.3% q/q growth recorded in Q4.  Annualised growth of around 1.2% (i.e. roughly four times 0.3%) mightn’t sound very impressive.  And in truth it isn’t of course (recall that Irish GDP rose by 7.8% last year!).  But we must remember that potential growth in the euro zone is no more than 1% at present (vs. about 2% in the US and UK), so anything above that actually represents better-than-‘normal’ for the euro area economy in the current environment and will produce a narrowing of the output gap and a reduction in spare capacity in the zone. The return to above-potential (if still modest) growth explains why the unemployment rate has been trending down for over two years, now at 10.3% from its 12.1% peak in Q2 2013. 

Following full-year average growth of 1.5% in 2015, the ECB expects a slightly slower but still above-potential 1.4% this year.  That equates to around 0.3-0.4% per quarter over the next few quarters i.e. perhaps a shade firmer than the economy’s recent run-rate.  However, importantly, Draghi repeated the ECB’s view that the risks around the euro area growth outlook still remain tilted to the downside amid persisting uncertainties relating to the global economy and to geopolitical risks.  That is, the ECB retains a very clear and explicit easing bias as emphasised by the following key extract from yesterday’s statement:

“Looking forward, it is essential to preserve an appropriate degree of monetary accommodation as long as needed in order to underpin the momentum of the euro area’s economic recovery and in order to accelerate the return of inflation to levels below, but close to, 2%. The Governing Council will continue to monitor closely the evolution of the outlook for price stability and, if warranted to achieve its objective, will act by using all the instruments available within its mandate”. 

Whether the ECB will need to act will be determined by how the economy and its outlook evolves in the period ahead, and in particular by the extent to which,

  • incoming news on growth validates current ECB expectations;
  • second-round effects of persistently low inflation take hold in wage and price setting;
  • inflation expectations pick up, or not; and
  • an unwanted tightening of broad financing conditions that could jeopardise the recovery. 

Draghi was probed on points three and four in particular yesterday, as journalists sought his views on the facts that the euro currency has risen not fallen and market measures of inflation expectations have gone down not up since the March stimulus package was unveiled. Draghi didn’t really engage on the currency question, and on price expectations could only offer an observation that we need to be patient to allow time for the ECB’s measures to take hold and work their way through both financial market and the real economy.  So the bottom line is the ECB is in wait and see mode, but with a very clear bias to ease policy further by using all of the tools (including interest rates) in its toolbox if needed. Markets are currently priced for a further 8bps or so of a reduction in the deposit rate by year-end, and if the ECB doesn’t deliver on that then it will risk the unwanted tightening of financial conditions it says it is keen to avoid.  Despite some very choppy price action yesterday afternoon, the euro opens this morning down just a touch against both the dollar and the pound, trading at $1.1270 and 78.7p respectively.

US Jobs

Meanwhile in the US, initial jobless claims published at a 40+ year low, following up last week’s 253k with an even lower 247k – the last time initial claims were this low there was over a 100 million less people in the country. Needless to say, this is extremely encouraging and consistent with a labour market that continues to improve at a very healthy pace – an important sign for the current policy debate at the Fed. The 4 week moving average also declined for the second week running, adding further robustness to the result. Less encouraging was the Philly Fed business index falling significantly more than expected, from 12.4 to -1.6 in April, casting an element of doubt on the sustainability of the sharp gains made in US manufacturing survey indicators last month.

In other news, UK retail sales continued the trend of the disappointing labour market results the day before as headline sales slipped from 3.6% to 2.7% y/y (despite supportive base effects) and core (ex. motor fuel) sales growth fell from 3.7% to 1.8% y/y. Like yesterday (and other downside surprises in UK economic data recently) however, the currency reaction was muted, with current pricing already reflecting a large degree of Brexit risk.

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