The European Central Bank holds a two-day monetary policy meeting this week with its first policy decision of the year due at 12:45 GMT on Thursday. Following surprisingly hawkish minutes of the December meeting and a series of data beats, expectations have risen that the ECB will end its asset purchase program (APP) when the current one expires at the end of September 2018. However, a stronger euro could pose a threat to the Eurozone’s improving growth and inflation outlook, prompting the ECB to strike a more cautious tone with its plans to wind down its stimulus program.
In December, most Governing Council members agreed that the Bank’s communication should “evolve gradually” to reflect the progress made with inflation. The minutes suggested policymakers were considering revising the forward guidance in early 2018 so as to shift the focus from bond purchases to interest rates. This fuelled speculation that the ECB is unlikely to extend the APP beyond September 2018 and that rates could begin to rise at the end of 2018 rather than in 2019.
The minutes, released on January 11, added fresh impetus to the euro’s end of year rally, helping the single currency break above the $1.23 level for the first time since December 2014. But the euro’s impressive streak has already caught the attention of ECB policymakers as several have come out during the past week to warn against an excessive rise in the exchange rate. The what appeared to be coordinated comments were followed by a Reuters story that according to ECB ‘sources’ the central bank is not planning on making any changes to its forward guidance just yet.
This indicates the ECB will be sticking to its existing language on Thursday and President Mario Draghi will likely use his press conference to quash speculation of an early exit from QE and to indirectly raise concerns about the negative effects of a sharp appreciation of the euro. With Eurozone inflation still running below the ECB’s target of close but below 2% (1.4% in December), Draghi will not want to risk upsetting the recovery by driving up the euro.
The recent surge in oil prices raises the possibility of CPI meeting the 2% target sooner than anticipated. However, some of those gains will be offset by the stronger exchange rate, whose effects could be more pronounced in the core CPI rate, which the ECB puts more focus on for assessing the underlying trend of inflation. Investors could therefore be complacent about the impact of the euro’s strength on ECB policy and underestimating the risk of a rising currency prolonging the QE exit timeline.
If the ECB keeps monetary policy and its forward guidance unchanged on Thursday as expected, the euro’s response will depend on whether Draghi will flag the March 7-8 policy meeting as the likely date when it will revise its communication. This is very probable given that new staff forecasts will be available by then. The euro could jump to $1.25 in such an event. A more limited upside move is likely if Draghi gives little away regarding future policy direction but refrains from using strong verbal intervention to put a cap on the euro’s gains.
However, the single currency could come under selling pressure if the ECB sticks to a cautious price outlook and reiterates the importance of maintaining its asset purchases until inflation is on a sustained upward path. Any signs that the ECB is abandoning the link between bond purchases and inflation in its guidance would only fuel the euro rally and Draghi would not want to be seen raising such expectations prematurely. A dovish stance on Thursday could push the euro below recent support near $1.2165.
 when the current one expires at the end of September 2018. However, a stronger euro could pose a threat to the Eurozone’s improving growth and inflation outlook, prompting the ECB to strike a more cautious tone with its plans to wind down its stimulus program.){kind=link}