Gearing Up

The ECB revised down its forecast and seems to have focused on downside risks, especially for inflation. It has changed one parameter of the QE programme, and may well implement extra policy action should financial conditions tighten and/or risks to price stability become more permanent.

In a dovish press conference in line with our expectations, the ECB revised down its growth and inflation projections. The Bank also upped the issue limit for its QE programme, and reiterated that it stands ready to deploy extra policy measures if financial conditions or the outlook for price stability were to warrant further action.

Small change to the QE programme: A dovish press conference as expected was accompanied by one measure which was perhaps unexpected by the market. Showing that the ECB still has room for manoeuvre and the asset purchase programme can be deployed flexibly, President Mario Draghi has announced that the issue limit has been increased to 33% from 25%. This would allow the Bank to continue to buy assets in Ireland and Portugal, if the QE programme were to be extended beyond September 2016. This is to be checked on a case by case basis, because the Bank can’t have blocking minority. Yet, beyond this, the Governing Council hasn’t decided to push for further action at this juncture.

Downgrade to the growth… Renewed downside risks have emerged to the outlook for GDP and HICP. But the Governing Council judged it premature to say whether this could have an impact on the medium-term goal of price stability, or whether these risks should be considered more transitory in nature. According to the September Staff Projections, GDP is now expected to increase by 1.4% in 2015, 1.7% in 2016 and 1.8% in 2017. Compared with the June Staff Projections, the outlook for real growth has been revised down, mostly given weaker external demand especially in emerging markets. Risks remain to the downside. They have also increased relative to these new forecasts as the cutoff date was August 12, so the projections don’t capture the volatility of the past couple of weeks. And what’s new is that downside risks are now seen on both growth (as before) and inflation.

…and inflation forecasts: We may see some negative inflation prints in the coming months. The Governing Council thinks these are mostly transitory effects due to the fall in oil prices (like us in our Autumn Outlook), but it’s monitoring all incoming information and are willing and able to act by using all instruments within its mandate. Based on current futures prices, HICP will likely remain very low in the near term. It’s expected to rise towards year-end, also on account of base effects associated with oil price dynamics in late 2014. Yet the increase is now seen to materialise somewhat more slowly than the ECB had expected thus far. The Staff projections now put HICP at 0.1% in 2015, 1.1% in 2016 and 1.7% in 2017, lower than before.

Can the ECB do more? Mr Draghi says that the Bank can “gear up” monetary policy further. As in July, the ECB reiterates that it stands ready to act, if an unwarranted tightening in financial conditions, broadly defined, were to materialise. What’s more, monetary policy action would be warranted if the medium-term outlook for price stability were to change materially.

Chances of the ECB stepping up have increased: We wouldn’t rule out that the Bank decides to act in October, even though it may want to wait until December, when a new set of forecasts will shed further light on whether the ECB Staff sees the current developments as more transitory or whether they have become more permanent. If the ECB was to step in and embark on further concrete policy actions, we expect it would probably:

• up the pace of QE above the current €60 billion per month,
• add to the overall size of the QE programme beyond the €1.14 trillion by September 2016, or
• consider changing the composition of the purchase programme by either making the interventions more targeted or by broadening them to new markets.

Even though the ECB statement explicitly mentions that extending the QE programme beyond September 2016 could be a possibility if necessary, on balance, we think that upping the pace of the purchases would be the most appropriate way to react at the moment. Therefore, we would deem such a step more likely than a simple extension of the programme. In judging whether the additional policy action is required, the ECB will also assess how the monetary policy stance is translating into financial conditions for the eurozone as a whole and for individual countries.

What does our financial conditions index say? It shows that financial conditions have not eased further in the month of July. So far, however, our index is not pointing to an unwanted tightening in financial conditions either, and still points to accommodative overall monetary and financial conditions. But stay tuned for when we get our hands on the August data!

Morgan Stanley Research