Planning for the future
21 March 2017
With the Eurozone economy riding high on the global cyclical upswing and headline inflation reaching 2% year-on-year (y/y) in February, debate about the outlook for monetary policy is increasingly focused on when and how unconventional support is next withdrawn. While the ECB had committed to a continuation of the asset purchase programme through to December 2017, market participants are impatiently awaiting signals from the Governing Council about its plans for 2018 and beyond. As we anticipated, the March meeting brought little new tangible information; the Governing Council agreed to maintain interest rates at current levels, while stating its intention to keep policy rates at current levels or lower. Draghi also reiterated the Council's previous commitment to continue the asset purchase programme at €80bn this month and then at a slower pace of €60bn per month from April 2017 through to the end of December 2017, or beyond if necessary.
That said, and while acknowledging that the existence of downside risks, the Governing Council did highlight the firming of the recovery, reflected in both survey and hard data, and how these trends were supporting the policy choices made so far. Draghi noted that the boost to headline inflation had been driven by energy and food prices, while underlying inflation remains subdued: a warning that we have issued repeatedly in this publication. That said, the ECB's current forecasts suggest that core inflation will rise from 1.1% this year to 1.5% in 2018 and 1.8% in 2019. If these forecasts prove to be correct, we would expect further policy normalisation in 2018, with a pre-announcement in September. In particular, we would expect the ECB to maintain the current pace of purchases to the end of 2017 before tapering through 2018. What form might such tapering take? Because the ECB has tended to announce tranches of asset purchases along set time horizons we expect this to continue, with the ECB announcing six months at a lower level, say €40bn per month, and then a further six months at a lower level again (€20bn), before ceasing the programme altogether by end 2018. This approach would allow markets time to adjust and reduce the risk of financial conditions tightening too much as long as tapering remained tethered to rising underlying inflation. We expect interest rate normalisation to begin with the deposit rate, rather than increases in the main refinancing rate (see Chart 6).
However, two big questions remain. Firstly, would the ECB taper while simultaneously raising deposit rates, or would they move sequentially? Uncertainty remains high; recent comments from Council members suggest that the ECB is reviewing its options on this front. Although we think both could take place in tandem if the normalisation is gradual, a staged approach may prove more palatable. The second big question may render such debates premature anyway; that is, can core inflation realistically increase to the levels that the ECB is projecting in 2018? We think the risks to the ECB's inflation forecast are to the downside: our own forecasts only see core inflation rising to 1.4% in 2018 compared with the ECB's 1.5%, and 1.7% in 2019 versus the ECB's 1.8% (see Chart 7). If we are right, normalisation will be slower, with a further six months of asset purchases and the possibility of a delayed deposit rate hike.
Stephanie Kelly, Political Economist