ECB turns cautious

Via Westpac:

At the December ECB meeting, the Governing Council confirmed the end of net asset purchases and repeated the forward guidance that key policy rates will remain on hold “at least through the summer of 2019, and in any case for as long as necessary”.

In addition, they gave forward guidance on their reinvestment policy, stating they “intend to continue reinvesting, in full, principal payments from maturing securities… for an extended period of time past the date when we start raising the key ECB interest rates, and in any case, for as long as necessary”.

The major point of both pieces of guidance is the term “in any case, for as long as necessary”. As ECB President Draghi notes in the press conference, the guidance is both “date contingent” and “state contingent”, and “deliberately” keeps “optionality” in a time of “great uncertainty”.

In that regard, Draghi mentioned that risk was the “focal point” of the Governing Council’s meeting. While the ECB continues to describe the risks to their outlook as “broadly balanced”, they note that they are “moving to the downside”. This relates to already mentioned uncertainties regarding trade protectionism, emerging market vulnerabilities and financial market volatility, but also a new addition at this meeting, geopolitical risks.

Yet despite the increasing general uncertainty, the ECB core view remains relatively unchanged and still quite positive. The update to their macroeconomic projections at the December meeting saw growth revised down slightly by 0.1ppt in 2018 and 2019 to 1.9% and 1.7%, while 2020 remains at 1.7%. That growth outlook implies a slightly above-trend expansion in the economy and is consistent with their ‘goldilocks’ inflation projections of 1.8% in 2018 (+0.1ppt), 1.6% in 2019 (-0.1ppt) and 1.7% in 2020 (unchanged). In other words, the achievement of their mandate of inflation close to but below 2%.

For some, this may be surprisingly optimistic given the run of weaker data in the Euro Area of late. Indeed, at just 0.2%, Q3 GDP growth was the slowest quarter since June 2014. The expenditure detail shows household consumption up just 0.1%, government consumption 0.2%, capital formation 0.2% and a negative contribution from net exports offset by inventories. Annual growth is now back to 1.6% from 2017’s well above-trend 2.7%.

While Draghi acknowledged the weaker economic outcomes, he is clear in stating that current data shows “lower growth, not low growth”, and that it reflects some sector-specific and countryspecific factors. (To this view, it is worth keeping in mind that Q3 growth was influenced by a surprise 0.2% contraction in Germany, but that this coincides with the introduction of new pollution standards. Outside of Germany, most countries actually had a fairly decent quarter, with France and Spain recording 0.4% and 0.6% growth respectively.) Coinciding with these factors, softer external demand is also continuing to be given as a reason for softer growth by Draghi following its very large contribution to growth in 2017.

In short, 2018 is marked by a return towards (though still above) potential Euro Area growth. More importantly, the ECB are still confident in the “underlying strength of domestic demand”, backed up by the improving labour market.

So putting that all together, the ECB have “continued confidence, but increasing caution”. What that implies is that their base forecast remains a positive one, but the fan of possible outcomes has widened, justifying a flexible approach to policy. Indeed, 2019 portends a disruptive year in European geopolitics with European Parliament elections to be held in May. 2019 will see a new European Commission President as well as a new ECB President with Draghi’s term ending in October. And to national political conditions, the fourth chart to the right speaks for itself.

Expect the ECB to never reach lift off.

David Llewellyn-Smith


  1. The Germans are trying to merge DB with Commerzbank so they can bail out the ECB when their balance sheet ( which has plenty of corporate debt in it ) ends up looking like this.

    Since Mrs Merkel started in 2005 with her bag of tricks, there is no EU without ECB credits………despite all the denials the Target 2 balances will have to be reconciled one day

    • DB is toast – whilst Commerzbank is quite good actually.

      UK did that, granted under dire circumstances, mergers with RBS and Lloyds almost took down those two institutions and wiped out tens of billion of Pounds in equity, with the Government stepping in as guarantor. Those banks have never recovered… and the government, which saved the day, has never seen its investment back either (pennies in the pound).

      Point I am trying to make, Commerzbank is no where big enough to absorb DB debt profile. The German government will have to eventually step in. Investors will lose everything.

  2. AEP on ECB shuts down historic QE experiment, before the job is done (

    The European Central Bank is to halt its €2.6 trillion programme of bond purchases this month despite the deepening economic slowdown in the eurozone and the lack of any safety buffer against a deflation shock.

    The four-year blitz of emergency stimulus saved the European banking system and helped lift Europe out of an economic slump but has failed to generate self-sustaining momentum.

    Core inflation remains nailed to the floor at 1.1pc. Such a low level at this late stage of the cycle raises the risk of deflation and poisonous debt dynamics in the next recession.

    Mario Draghi, the ECB’s president, said quantitative easing had been a resounding success given the impossible circumstances. It was the “only driver of this recovery” at crucial moments.

    Critics say the ECB waited too long before launching QE in early 2015 – six years after the US Federal Reserve – and allowed the deflationary forces to become lodged in parts of the system. It may now be trapped. The window is closing as the ageing global expansion fades.

    Mr Draghi warned of “downside risks” to the economy but stuck to his line that the sudden slowdown over recent months is a hiccup caused by one-off factors and disruption in the car industry. The ECB tweaked its forecast slightly but is still banking on growth of 1.7pc next year.

    “It is the usual soothing babble from the ECB,” said Ashoka Mody, a former bail-out chief for the International Monetary Fund in Europe. “They are seriously underestimating the pace of the slowdown. China’s stimulus has run out and this is causing a world trade slowdown, with cascading effects through the global economy.”

    Professor Mody, now at Princeton University, called it a grave policy error to declare ‘mission accomplished’ and cut off stimulus when it has failed to meet its inflation target and while growth is crumbling.

    Italy has one foot in recession. It faces an incipient credit crunch. Germany contracted in the third quarter. The Sentix index of business expectations for the eurozone has fallen to minus 18.8, the lowest since the EMU banking crisis in 2012.

    Gilles Moec, from Bank of America, said his tracking model shows that growth has stalled to an annual rate of 0.5pc and that core inflation is trapped in a range of 0.7pc to 1.1pc. “We believe the ECB is well aware of this, and its repeated messages of optimism have more to do with the political need to do away with QE than with its actual assessment of the current situation.”

    This is a polite way of saying that the ECB has hit a host of political constraints and is being forced to abandon stimulus too early. Bank of America suggested that the ECB is knowingly issuing inflated growth estimates in order to justify its actions. Some might deem this an astonishing situation.

    Mr Draghi insisted that policy is still “very accommodative”, citing buoyant investment. Interest rates are minus 0.4pc and will stay there until the Autumn of 2019 or beyond.

    The ECB says the ‘stock’ of bonds held by the ECB will remain constant – implicitly for two years or more – as redemptions are reinvested. Markets put more weight on the ‘flow’ effects. Seen in this light the spigot is clearly being turned off.

    The eurozone money supply has already slowed sharply. The growth rate of broad M3 money was running at 5pc levels during the peak QE years, when the ECB was buying €80bn of assets each month. The rate has since halved (on a three-month annualized basis) as purchases taper off.

    M3 growth is almost certain to drop below 2pc next year by mechanical effect. Tim Congdon from the Institute of International Monetary Research said the eurozone is repeating the errors of 2011, sleep-waking into a recession. “They risk a disaster,” he said.

    Prof Congdon said eurozone policy had become hostage to a political struggle between North and South Europe, describing it as a state of “monetary civil war”.

    The ECB is hitting technical and political limits. Its balance sheet has soared to 42pc of GDP. There is a scarcity of high-grade assets to buy. The bank pinned its colours to the mast long ago by stating that further purchases might be tantamount to monetary financing of deficits, risking a violation of EU treaty law. A German-led bloc of monetary hawks is using this to shut the programme.

    Behind this lies a further worry. A side-effect of QE is an explosion in the Target2 liabilities of southern central banks within the ECB’s internal payment system.

    The Bank of Italy’s ‘debt’ to the ECB has reached €492bn, while the Bundesbank’s ‘credits’ have hit €928bn. This causing a political storm in Germany since it amounts to covert financing for capital flight from Italy without democratic assent from the German parliament. Losses could be huge in a euro break-up scenario.

    The ECB continues to forecast inflation of 1.7pc in 2020 and 1.8pc in 2020 but this has been a ritual for the last five years. Every time it predicts an inflation rebound, and every time it fails to happen.

    “This is not the right time to stop QE. The situation has been deteriorating for months,” said Zsolt Darvas from the Bruegel think-tank in Brussels.

    Whether the ECB can alone lift the eurozone out of a ‘lowflation’ trap is an open question. Mr Darvas said there are parallels with Japan’s long and forlorn struggle to break free.

    The problem is that the eurozone is not a cohesive nation like Japan with a unified fiscal and monetary system working in tandem. Euroland’s constituent parts are far more vulnerable to a debt crisis. “Italy is the fault line. The ECB is the only organization buying its debt and this is about to stop,” said prof Mody.

    “Italy’s real interest rate is around 2.5pc and it is the real interest that counts. With a growth rate near zero this is unbearable. The underlying numbers are cruel. Slow, creeping debt-deflation is inevitable and will become progressively worse,” he said.

    Prof Mody said the ECB has also been soaking up most of the net debt issuance of Spain and Portugal. “They are declared model performers but will we will see what happens when the tide recedes,” he said.

    He said the EU authorities had become obsessed with the minutiae of Italy’s budget deficit, seemingly oblivious to the much more potent issues about to engulf them. “They are like a drunk man looking under the lamppost because that is where the light is. They don’t seem to realize that the tsunami of rising world interest rates and slowing trade is about to sweep them away,” he said

    In the end the ECB may be forced to restart QE but only once circumstances are desperate. The bar is prohibitively high. “At best, there will be delays and half measures. The reality is that ECB cannot set monetary policy for nineteen very diverse countries. It is one-size-fits-none,” he said.

    Vitor Constancio, until recently the ECB’s vice-president, said the US is heading for a deep slowdown or recession over the next one to two years. This will have serious knock-on consequences for Europe. He warned that the ECB cannot hold the line a second time. “Monetary policy alone is not enough. Fiscal policy must step in,” he said.

    No such EMU fiscal machinery yet exists.