Draghi: “Monetary transmission has never worked better”

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When ECB president Draghi said (during the press conference after the ECB’s meeting on 08/09/16) that the monetary transmission mechanism had never worked better than it does currently, he was probably deliberately exaggerating. Nonetheless, he does seem genuinely pleased with the outcome of current ECB policy. According to the ECB’s analysis, credit markets in the eurozone are no longer fragmented and credit is reaching the private sector. Draghi pointed out that negative side effects such as lower bank profitability or cash hoarding have been limited – so far.

With inflation low but stable, and a relatively positive economic outlook, the ECB sees no reason to change its policy stance. While the consensus among analysts, including us, had been for an extension of the asset purchasing programme beyond March 2017, Draghi said the option to prolong quantitative easing did not even come up at the policy council meeting on 08/09/16.

The ECB has left the door open

The reaction from financial markets was negative, but only briefly so: equities fell before recovering quickly, and the spike in the euro versus the US dollar was short-lived. In itself, that can be seen as positive since it could indicate that markets have finally become less addicted to accommodative monetary policy. However, we think the main reason is that the ECB left the door open to an extension of the programme, possibly in December.

Committees within the ECB have been tasked with looking at the options for a smooth implementation of the asset purchases in the context of the growing scarcity of some of the bonds the ECB is buying under the programme. At the current pace and under its current rules, the ECB may run out of German Bunds to buy later this year or early next year.

Some of the rules are self-imposed. Thus, the ECB may allow itself to buy more than 33% of any specific issue, may buy bonds with a yield lower than the ECB’s deposit rate (currently -0.4%) or, more controversially, abandon the capital key[1], which would allow the ECB to buy relatively more Italian or French bonds. Apart from mentioning this assessment process, Draghi repeatedly said that the purchase programme will run through March 2017 or beyond, if necessary.

Growth may disappoint

So what could change between now and December? Eurozone economic growth may disappoint the ECB’s relatively optimistic projections. To get to the 1.7% year-on-year pace forecast by the ECB this year, GDP growth needs to accelerate to above 0.4% quarter-on-quarter (QoQ) in the second half of 2016. However, leading indicators such as consumer confidence, the Economic Sentiment Index and the manufacturing and non-manufacturing PMIs have weakened lately. In the second quarter, GDP growth slowed to 0.3% QoQ, which was partly due to payback from the strong first quarter, but the composition was poor: slow growth in consumption and no growth in investment.

Persistently low inflation is already a concern for the ECB (see exhibit 1 below). The central bank projects inflation below its 2% target up until 2018 and at this point does not see a convincing uptrend in any underlying price pressures, even with accommodative monetary policy and exceptionally supportive financing conditions. We do not expect this to change much before December, so once the committees have found ways around the scarcity of selected bonds, we expect the ECB to extend its asset purchase programme in December.

Exhibit 1: The persistently low rate of inflation is a subject of concern for the ECB

(The graph shows changes in the HICP (Harmonised index of consumer prices) headline and core inflation rates relative to the ECB’s target for the period from January 2000 through 12/09/16)

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Source: Datastream BNPP IP [divider] [/divider]

[1] Capital key refers to the buying of government debt in proportion to eurozone countries’ shareholding in the ECB. Germany is the largest shareholder, meaning that German government bonds make up the largest portion of the ECB’s asset purchase programme under current rules.

 This article was written on 12 September 2016 in Amsterdam

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