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ECB to stick to its guns

ECB to stick to its guns

5.9.2013 9:29

In August, the ECB left policy unchanged, which was no surprise after it had cut rates in May and introduced a loose form of forward guidance in July. At the margin, ECB President Mario Draghi sounded a little more confident that a gradual turnaround in the Eurozone economy had begun. For this week’s meeting, we expect more of the same: no policy changes, no suggestion that near-term policy changes are likely and no major changes in the ECB’s assessment of the economic outlook. Somewhat stronger economic data have eased pressure on the ECB to do more to support the economy.

Nevertheless, we don’t expect any triumphalism, which would of course be totally inappropriate after six quarters of negative growth and also premature given the persistence of significant risks to a still tentative turnaround. Indeed, the increased geopolitical tensions, following the gas attack in Syria and the likely retaliation of the US, and its repercussions on the oil price are but the latest reason for the ECB to remain cautious on the economic outlook and stick to its current policy stance.

With monetary developments still weak enough to warrant some concern, the ECB is expected to keep its forward guidance including an easing bias unchanged, and keep a dovish tone for now.

Why? First of all, the euro economy grew again in Q2 of 2013, following six quarters of negative growth. Combined with other data (business and consumer confidence, unemployment), the underlying picture will be one of an economy that is returning to a path of positive growth. The unemployment rate stabilized in July at 12.1% for the fifth month in a row, nevertheless the underlying situation appears to have improved somewhat of late. Still, unemployment is at depression-like levels. While we look for a better economic environment, there is no reason to expect the economy to close what is a big output gap in the foreseeable future. That is a key reason why a tighter ECB policy is out of the question for many quarters to come.

In what could be quite a dull event, markets may focus— possibly too intensely—on what are likely to be modest changes to the ECB forecasts which will be presented by Mr Draghi. Following solid data for the second quarter, the ECB are likely to predict a smaller contraction in Euro area GDP this year. Our judgement is that the 0.6% drop, envisaged in the June forecasts, will be too pessimistic, especially after the upward revision to the GDP data.

Therefore, a quite significant upward revision to the 2013 GDP date is likely. An altogether more interesting issue is whether the ECB see this additional momentum being sustained into 2014. any material upgrade of the previous expectation of GDP growth of 1.1% might unnerve some as it would suggest the Euro area economy would soon be growing at something close to its current potential rate (even if it will take some time to close a large output gap).

There may also be some upward revision to the ECB’s inflation forecasts. With oil prices somewhat firmer of late, we could see a marginal increase in the forecast for 2013 and there could be some scope for a somewhat larger upward revision to the 2014 number on energy prices and a marginally firmer trend in activity. It should be emphasised that any plausible revision would still leave the 2014 forecast towards the lower boundary of what might be consistent with the ECB’s target for price stability. That said, markets may respond to any revision of 0.2/0.3%.

A more optimistic set of projections could potentially cause markets some problems in that they would (not unreasonably be seen to diminish any likelihood of a further ECB easing and perhaps raise questions about whether the current policy setting would remain appropriate throughout 2014. Our judgment is that the ECB will not want to frighten the horses at this juncture.

So, a combination of conservative changes to forecasts and a cautious Mr Draghi will attempt to reassure markets that ‘an extended period’ of accommodative policy remains in prospect.

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