The ECB attempts to counter exchange rate volatility by slightly lowering its inflation forecasts and sending markedly accommodative signals on APP and policy rate management……
The bond markets reacted accordingly, the exchange rate less so.
The ECB meeting brought no changes on rates and non-standard measures. The rhetoric of the statement and the tones used by President Draghi reveal the intention to avoid rocking the boat and to cool expectations for a tightening of monetary policy, that had caused some turmoil on the currency markets. The ECB clearly took stock of the recent trend of the exchange rate (+4.7% since the beginning of May) and of financial conditions. As always, the President of the ECB could not comment on the level of the exchange rate, but said that there was widespread consensus within the del Council on the fact that recent volatility represents a factor of uncertainty and concern, and must be monitored closely. For now, this effort has not been rewarded by the currency markets, whereas the interest rate market immediately acknowledged the accommodative tones with a drop in medium-long term rates and a compression of risk premiums on peripheral issuers.
The statement promises that the ECB will be active on the markets beyond December 2017 as well, and will “gauge” non-standard measures based on the evolution of the macroeconomic scenario and on the prospects of inflation returning to the 2% target in the medium term. At the same time, the ECB has renewed its commitment to keeping policy rates stable well beyond the termination of purchases: Draghi reasserted that the sequence of actions remains as planned. Decisions on the extension of the APP (Asset Purchase Programme) will be taken in October. For the time being, the Council has only considered alternative scenarios, without taking into account possible changes in purchase implementation parameters, concerning in particular the limit imposed on individual issues and issuers. On the other hand, the Council considered alternative scenarios for the duration and volumes of purchases, but is waiting for indications from the various working groups.
Evidence of the fact that the ECB is in no rush to tighten monetary conditions, the central bank staff revised down by one tenth its inflation estimates, to 1.2% and 1.5% in 2018 and 2019 respectively, prompted by the stronger exchange rate. Inflation forecast revisions were entirely due to the weaker underlying trend (net of energy and food prices) compared to June. Forecast core inflation is now lower, at 1.3% in 2018 and 1.5% in 2019. If the currency movement were entirely due to external factors, transmission to inflation would be stronger; however, it is in fact due in part to an improvement in the economic and political picture. Growth forecasts have been revised up to 2.2% in 2017 from 1.9% previously, whereas estimates for the next two years are stable at 1.8% and 1.7%, as the ECB believes the underlying trend of the euro area economy is stronger than estimated a few months ago, and that this will balance the effect of the stronger exchange rate. Furthermore, monetary policy will counter in part the headwind represented by the appreciation of the euro. The downward revision of core inflation forecasts for the next two years, and in particular the 1.5% estimate for 2019, is an important signal, as it reduces the ECB’s urgency to exit the purchase programme. Council members generally believe the expansion phase will translate, over time, into an increase in domestic prices, although for the time being they consider it necessary to be persistent in supporting growth and the rise in underlying inflation.
In our view, the ECB will announce a very gradual exit from the purchase programme in October, adopting a flexible formula, without indicating a predetermined termination date, and reserving to gauge purchases meeting by meeting. The central bank will probably seek to extend the programme until the autumn of 2018, although the final decision will depend on the political balance within the Council and on the evolution of the economic picture. For the time being, we have reason to expect an initial deposit rate hike no sooner than 2019.
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