ECB shows continuing confidence with increasing caution

The ECB Governing Council left its policy rates unchanged and announced that net asset purchases will cease by end-year. The results of the meeting were broadly in line with our and broader market expectations. ECB President Draghi described the economic expansion as ongoing, even if incoming data had been on the weaker side. He said that much, but not all, of the weakness was explained by idiosyncratic factors that were deemed to be temporary. While the Governing Council still sees risks to the economic outlook as “balanced”, it added that the balance of risks has been moving to the downside. Thus, the Governing Council still has confidence in its base case, even if increasing risks call for caution. New information was offered regarding the approach that will be taken towards reinvesting the proceeds of maturing bonds in the APP portfolio as net purchases end: this is broadly in line with existing practice, as we expected.

The Introductory Statement showed that the ECB maintains a relatively robust view on economic growth. The expansion is seen as ongoing. Recent weaker-than-expected incoming data are attributed to idiosyncratic sector- and country-specific factors, even if such one-offs cannot fully explain the slowdown. Mr. Draghi noted the negative impact of external factors, but argued that the domestic economy continues to show strength (including in the labour market, where employment growth and higher wages underpin consumption).

The staff macro-economic projectionsembodied a small downward revision to GDP growth in both 2018 (-0.1pp to +1.9%) and 2019 (-0.1pp to +1.7%). The sequential growth profile shows growth at +0.4%qoq in Q4 and +0.5%qoq during the first three quarters of 2019, followed by a slowdown to a +0.4%qoq sequential expansion throughout the remainder of the forecast horizon. The December projections include an additional forecast year. GDP growth in 2021 is expected to be 1.5%. GDP growth forecast is close to the ECB’s projections. The Introductory Statement maintained that the risks to the outlook remain balanced, even if “the balance of risks is moving to the downside”. Underlying this assessment, Mr. Draghi pointed to risks stemming from geopolitics, protectionism, EM vulnerability and financial market volatility.

On inflation, the Introductory Statement text was broadly unchanged from October, stating that “measures of underlying inflation remain generally muted, but domestic cost pressures are continuing to strengthen and broaden amid high levels of capacity utilisation and tightening labour markets, which is pushing up wage growth”. Underlying inflation is still expected to increase gradually over the medium term supported by the ECB’s monetary policy measures.

The updated staff macroeconomic projections made some changes to the inflation forecast, Mr. Draghi noted the recent increase in wage growth − to +2.5%yoy in Q3 – and argued that it would support higher inflation in the future, even though the pass-through of wages into prices remains uncertain. The Governing Council confirmed that net new asset purchases would cease at year-end, as expected and in line with the plan Mr. Draghi outlined last June. Guidance on the reinvestment of principal on maturing bonds was left broadly unchanged. Mr. Draghi said that reinvestment would continue for “an extended period of time” after the first rate hike. The reinvestment will still take place ‘in any case for as long as necessary’. Mr. Draghi said, when asked, that the Governing Council did not discuss a more time explicit guidance on reinvestments.

As expected, an update on the technical parameters governing reinvestments was published. The ECB said that the allocation of bond holdings across eligible jurisdictions will continue to be guided by the ECB’s capital key and “as a rule, therefore, redemptions will be reinvested in the jurisdiction in which principal repayments are made, but the portfolio allocation across jurisdictions will continue to be adjusted with a view to bringing the share of the PSPP portfolio into closer alignment with the respective national central banks’ subscription to the ECB capital key”. Any adjustment will be gradual. The ECB added that limited and temporary deviations from the guidelines may occur for operational reasons and that reinvestments could be distributed over a twelve-month window “to allow a regular and balanced market presence”. Also as expected, the ECB’s principle of market neutrality will be maintained. The ECB did not implement a ‘twist‘, as some market participants had discussed.

 The forward rate guidance remains unchanged. The Introductory Statement reaffirms – in its ‘date dependent’ guidance – that the ECB expects policy rates to remain at their current levels “at least through the summer of 2019”. The current guidance still offers flexibility in terms of what will happen after the summer next year – the Governing Council maintains a ‘state dependent’ rate guidance (in addition to the date guidance), indicating that rates will be on hold for as long as necessary to ensure the continued sustained convergence of inflation. The ECB stands ready to adjust all its programmes if necessary, and Mr. Draghi said during the press conferences that the APP had become a permanent part of the tool box.Mr. Draghi received some questions on a possible new round of T-LTROs. He said that some members had mentioned this, but that it was not discussed in depth at today’s Governing Council.

With little new information offered at today’s press conference, our base case remains unchanged. Net asset purchases will cease by year-end. We expect the first rate hike to come in Q4 2019. We expect the first hike to be 20bp. We see a outcome for the ECB rate path, with  implying interest hikes in Q4 2019 and a pace of hikes of 25-45bp per year over our forecast horizon; our downside risk path has a first hike only by mid-2020 and a pace of hikes of 20bp-25bp per year .