• No major surprises from Mr Draghi; ECB in ‘assessment’ mode
  • Differing views within ECB on scale of EMU slowdown
  • Retaining maximum flexibility while not signaling prospect of policy shift
  • Draghi keeps wriggle room on future TLTRO’s

Yesterday’s policy meeting of the ECB’s governing council didn’t deliver any major surprises but it did hint at some differences of opinion that could have implications for when and, potentially, even which direction ECB policy next changes.

ECB in assessment mode

At present, the ECB is trying to evaluate an evolving economic situation and, as Mr Draghi emphasised repeatedly, the governing council did not discuss policy options. The ECB is now firmly in ‘watching and waiting’ mode rather than contemplating or preparing any near term alterations to the current policy stance.

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An acknowledgement of downside risks to the outlook for the Euro area economy implies that any material tightening of ECB policy entailing an initial rate rise is still a distant prospect.

Indeed, Mr Draghi’s acknowledgement of differences of opinion among ECB policymakers in relation to how severe and persistent the recent weakening in growth may be might even hint that some on the ECB governing council may be considering whether some further easing of policy might be warranted before long although Mr Draghi’s highlighting of this divergence doesn’t seem to have prompted any immediate market reaction.

Mr Draghi emphasised that the ECB is focussed on an analysis of recent slower growth and as these deliberations hadn’t produced definitive answers to the questions of ‘where we are, why we are here and how long will the slowdown last’, the ECB hadn’t considered the policy implications of the weaker trajectory of the EMU of late.

Muted immediate reaction

More importantly, markets also believe that recent slower growth doesn’t point to any early alteration to the policy path consistently signalled since June 2018 in which ECB policy rates are expected ‘to remain at their present levels at least through the summer of 2019, and in any case for as long as necessary to ensure the continued sustained convergence of inflation to levels that are below, but close to, 2% over the medium term.’

A small change in thinking

At its previous policy meeting in December, the ECB had noted that the balance of risks to the outlook for activity was ‘moving to the downside owing to the persistence of uncertainties related to geopolitical factors, the threat of protectionism, vulnerabilities in emerging markets and financial market volatility.

In light of a sequence of disappointing activity indicators of late, Mr Draghi ventured that risks had now ‘moved to the downside’, citing the same list of factors as in December. That this is a small and sequential nature of this adjustment is further hinted at in the explanation that ‘incoming information has continued to be weaker than expected..’

Significantly but not surprisingly, the opening press statement repeats earlier confidence that a range of factors encompassing ‘supportive financing conditions, favourable labour market dynamics and rising wage growth continue to underpin the euro area expansion and gradually rising inflation pressures’.

In turn, this is seen prompting the eventual return of inflation to target (and keeping ECB policy on its current path). Asked why price pressures had not materialised to this point, Mr Draghi suggested that rising wage pressures were squeezing profits at present. So, an uptick in inflation is expected to be simply ‘a matter of time’.

Mr Draghi spent much of the press conference discussing the various factors forces driving ‘the increase in general uncertainty’ that is now weighing on the pace of growth in the Euro area economy. He indicated that ‘the key aspect to assess is the persistence of the general uncertainty’.

Unusual emphasis on differing opinions

While Mr Draghi said that there was unanimity within the ECB governing council that the likelihood of recession was low, he did note that there were two viewpoints in relation to the likely persistence of uncertainty and related weakness in growth . One view was that the weakness would likely ‘wash out’ as policymakers addressed concerns such as those in relation to trade and the slowdown in China.

The other view emphasised that the ‘downside movement‘ in all indicators of Euro area activity had lasted several quarters and as risks were unlikely to disappear, this was now affecting confidence. Mr Draghi concluded that the Governing council would ‘give itself more time’ and the benefit of new projections to assess economic prospects.

We draw attention to Mr Draghi’s elaboration of these conflicting viewpoints because it is unusual for the ECB to set out in any detail the rationale behind differing views around the table of its governing council (although it is the norm in minutes of policy meetings of the US Federal Reserve). We think there could be several reasons for Mr Draghi’s ‘openness’ in this regard.

It could be the case that the Euro area is at a pivot point at present in which one of two very different paths lies ahead. The first would see temporary constraints on growth fade leading to a return of solid momentum as 2019 progresses. With the assistance of a tightening labour market, this would see inflation pressures progressively build. In these circumstances, the ECB might be in a position to begin to tighten policy, possibly as early as the end of this year.

An alternative path for the Euro area economy would see trade and sectoral disruptions persist and weigh more heavily on sentiment thereby weakening consumer spending and investment. In extremis, such circumstances could even call for a further policy easing and while Mr Draghi said that he didn’t want to speculate about what contingencies would call for specific instruments, he added that ‘we have all our tool box still available’ .

Nudging markets

By setting out differences in views within the governing council as to the economic outlook, Mr Draghi first of all discourages the view that the ECB are on an ‘automatic pilot’ course towards tighter policy later this year. Arguably, a sense that the Federal Reserve was on such a pre-set course was an important element in recent market turmoil and led to an awkward restatement of policy intentions by senior Fed officials in recent weeks.

The subtle outline of differing governing council views also puts the ECB in a position where it can readily tilt its policy guidance in March or subsequently depending on the health or otherwise of economic indicators in the interim and explain such a development as the natural evolution of earlier thinking into a consensus view.

Probably of greatest significance, by nuancing comments about governing council views, the ECB can move market expectations and thereby ease (as is presently the case) or tighten financial conditions without having to formally precommit through an explicit change in policy guidance.

In this context, Mr Draghi highlighted that the markets’ understanding that the nature of the ECB’s policy guidance was ‘date but also state contingent’ had already produced market movements that reflected an understanding of the ECB’s reaction function.

So, it could be suggested that by nudging the markets in this way, Mr Draghi is implementing a form of verbal easing. In this regard, he later added that some of the ECB’s instruments had already played an accommodative role in recent months whereas the activation of others would depend on the evolution of growth.

The markets sense of the ECB’s reaction function is hinted at in the graph that shows the relation between the composite purchasing managers survey for the Euro area and futures markets expectations of the three month money rate in December. The graph implies markets are firmly of the view that the path and pace of future ECB policy rate changes will be significantly dictated by the health (or otherwise) of the Euro area economy.

More TLTRO’s likely but not just yet

Mr Draghi was asked several questions as to whether the ECB would consider a further round of Targetted Long Term Refinancing Operations (TLTRO’s). He initially responded that the policy meeting focussed on assessment rather than policies although he added that ‘quite clearly the assessment would have policy implications but we haven’t discussed them’. He later indicated TLTRO’s would have to have a policy role and wouldn’t be implemented simply as a sectoral subsidy (the first tranche of TLTRO’S which expire in mid-2020 will have diminishing usefulness for commercial bank’s liquidity ratios from the middle of this year).

As Mr Draghi noted that previous TLTRO tranches had reduced fragmentation between Euro area countries and thereby assisted the transmission of monetary policy, it should be possible to make some broadly supportive arguments for another tranche of TLTRO’s but this may be announced later than expected and could eventually be linked to other policy changes (as TLTRO’s should reduce the variability of impacts across countries of such changes).

A source of ongoing easing?

Finally, in response to yet another question on the ECB’s scope to respond to weaker economic conditions, Mr Draghi suggested that the ECB’s holdings were significant at 25% of the stock of eligible Government debt.

As Mr Draghi indicated that the aggregate stock of Eurozone long term bonds had fallen consistently since 2014 and was expected to fall further in coming years, it could be argued that the increasing share of the outstanding stock of government bonds held by the ECB represents an ongoing source of policy accommodation.

Mr Draghi suggested that the evidence of lower yields and flatter curves since last June when the ECB announced its intention to cease monthly net asset purchases was significant evidence of such support.

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