The tone of the March ECB meeting was more dovish than anticipated, with three key pieces of new information grabbing the markets’ attention.
- Change in forward guidance – further interest rate rises before 2020 explicitly ruled out
- A new Targeted Longer-Term Refinancing Operation (TLTRO-III) to support bank lending conditions
- Larger-than-expected downgrades to the ECB’s growth and inflation projections
Although the above announcements were unexpected either in terms of scale or timing, it is unlikely that they will meaningfully ease financial conditions in the eurozone. Why?
First, the change in the forward guidance on interest rates – from keeping rates unchanged “at least through the summer of 2019” to “at least through the end of 2019” – was modest. Market pricing had already pushed back expectations for the first rate rise into 2020 ahead of the meeting. In fact, several council members presented the option of changing the date of the forward guidance to March 2020, but this was resisted due to concerns over the consequences of a protracted period of negative rates and the associated implications for banks.
Second, the news on TLTRO-III lacked detail. The new series will be launched in September and expire in March 2021, each with a maturity of two years. The interest rate will be indexed to the rate on the main refinancing operations over the life of each operation. ECB President Mario Draghi announced there will be built-in incentives for credit conditions to remain favourable, but did not give details. With the last tranche to be originated as late as in March 2021, this ensures that bank lending conditions will remain favourable until March 2022, when the residual maturity of these loans falls to below one year. However, compared with previous TLTRO incarnations of three to four-year fixed rate loans, TLTRO-III is less generous and sends a weaker signal about the future path of policy rates.
Lastly, ECB staff economic projections were markedly less optimistic than those in December 2018. Calendar year growth for 2019 was revised down from 1.7% to 1.1%. Looking at the quarter by quarter projections, it is not surprising to assume weak growth in the first half of 2019 given recent data releases. Real GDP growth is projected to remain low in the second half, at around 0.25% quarter-on-quarter (QoQ) in both Q3 and Q4, roughly half December’s estimates.
While the downward revisions could send a dovish message, signalling more easing in the pipeline, the correct interpretation could be more nuanced, particularly as the ECB took action alongside weak forecasts. The latest projections establish a new economic baseline against which data outturns can be evaluated, and policymakers may argue that they need to see weakness relative to that new baseline before being convinced to do more.
The fact that further cuts in interest rates to deeper negative levels, or a resumption of quantitative easing, were not even discussed at the meeting suggests that the council has a relatively sanguine view about the current state of the economy. This contrasts sharply with the US Federal Reserve’s pivot over the past quarter.
The path of inflation returning to target – delayed, not derailed?
President Draghi’s description of the outlook remains one where growth weakness and downside risks arise mainly externally, with limited signs of spill-overs into domestic demand so far, and sustained convergence of inflation to the target has been delayed rather than derailed.
The inflation-lined bond markets seem to think differently. Having spent much of 2018 gyrating between 1.6% and 1.8%, the 5-year/5-year forward breakeven inflation (BEI) rate started to fall precipitously in Q4 2018 and reached a low of around 1.3% in March 2019, just several basis points above its all-time low in mid-2016. The decline is large by historical standards, and reflects both the expectations that eurozone inflation will remain low and scepticism of the ECB’s credibility on inflation. So far, Draghi has dismissed talk of inflation expectations being unanchored by referring to the stable survey-based measures, while pointing to a negative inflation risk premium for driving market-based expectations.
Exhibit 1: Market-based vs. analysts’ inflation expectations in five years' time
Source: Bloomberg, March 2019
It is reasonable for investors to worry about the ECB being late to ease and/or running out of ammunition. The political barriers to the ECB returning to unconventional monetary easing are high, and reaching consensus on the need for stimulus and then calibrating it is time consuming. We know the ECB can ease more if needs be, but how much pain might it take to force the ECB into action, particularly when the leadership is about to change this autumn?
Signs of the ECB preparing to do more, if necessary
Fortunately, there are signs that the ECB is preparing to do more if weak external factors spill over more significantly into domestic demand. First, the council retained the downside skew on the growth outlook, which could be understood as a signal that it is not done easing.
More recently, the discussion on deposit rate tiering restarted. Draghi hinted in late March that the ECB will reflect on possible measures to preserve the favourable implications of negative rates for the economy while mitigating the side effect of hitting banks’ profitability. One ECB board member later acknowledged that a “lower-for-longer” environment had triggered the discussion of a tiering system and “ECB sources” also revealed that technical committees are analysing options for such a system.
While it is too early to suggest that the ECB will be shifting its policy stance significantly, an adoption of a tiering mechanism would send a dovish signal. Tiering would probably be adopted alongside a “lower-for-longer” policy, and would also lend credibility to threats of further rate cuts.
This is an extract from the Q1 2019 Inflation-Linked Bonds Outlook published in March. To read the full version, click here > For more articles by Cedric Scholtes, click here > For more articles by Jenny Yiu, click here > For more articles on the ECB, click here >