Time for a change of heart at the ECB?

If recent surveys are to be believed, growth momentum in the global economy at the end of 2016 was the firmest for several years, with improved sentiment in the major and emerging market economies alike. That was certainly true for the euro area, where the data flow has been the most encouraging since the sovereign debt crisis. Indeed, the indicators which typically provide the most reliable guide to euro area GDP growth – the European Commission’s economic sentiment index and the composite purchasing manager index (PMI) – rose in December to their highest levels since the first half of 2011. And the detail of these surveys signalled the likelihood of a solid start to the New Year too.

Encouragingly, the improvement in confidence in the euro area is broad-based. With orders the most plentiful for more than five years both at home and overseas, and with stocks having been reduced, manufacturers are particularly upbeat about the near-term outlook. Confidence in the service sector is also at a multi-year high. Meanwhile, after a long and painful adjustment, the outlook for construction is the best since the collapse of Lehman Brothers. And, broadly tallying with more buoyant consumer confidence, which recently rose to its highest in almost two years, retailers are also more upbeat.  

The better economic mood is also evident across a wider number of countries, with notable improvements in sentiment to multi-year highs in France, the Netherlands and Germany. Unsurprisingly, confidence remains elevated in Spain, where growth has continued to beat all other member states and unemployment fell in 2016 by more than in any other previous year. Perhaps less expected in light of December’s political turbulence, economic confidence in Italy has recently remained above its long-run average. And, overall, euro area GDP now looks to have grown in the final quarter of 2016 by 0.5%Q/Q, the strongest rate in three quarters, led by Germany and Spain, but with a notable acceleration in France too. Given the solid momentum, the ECB’s full-year euro area GDP growth forecast of 1.7%Y/Y in 2017 also looks a reasonable bet, with – in a break from the norm – non-negligible upside risks to the outlook.

However, while the euro area’s improved growth prospects have provided cause for optimism, the most eye-catching recent economic data concerned inflation, which, according to the flash estimate, rose 0.5ppt in December to 1.1%Y/Y, the highest since summer 2013. The rise was driven principally by shifts in the oil price, with energy making a positive contribution to overall inflation for the first time in more than two years, as well as increased prices of food. But, having remained stable over the preceding four months, core inflation also picked up, to 0.9%Y/Y.

That uptick in core inflation hardly yet represents the sustained upwards trend that the ECB has been striving to achieve. And it is certainly too soon to tell whether it is an indicator of meaningful new pressures to come. In Germany, however, there are good reasons to believe that underlying price pressures will soon emerge from the tight labour market and vibrant property market. Indeed, in December German inflation jumped a much bigger-than-expected 1ppt – the most since the introduction of the single currency – to 1.7%Y/Y, the highest in more than three years.

For now, Germany looks to be the exception within the euro area, with rising inflation in other member states set to remain highly reliant on the upwards shift in energy prices rather than core pressures. Nevertheless, with the oil price close to $55pb and the euro having recently depreciated to a fourteen-year low close to $1.04, headline inflation in the euro area looks set to take a further step up to average about 1½%Y/Y in the current quarter and – in the absence of shocks – to continue to oscillate around 1½%Y/Y over the remainder of the year. Meanwhile, core CPI will likely remain more subdued with an average rate closer to 1%Y/Y. But given the country’s more advanced cyclical position, German inflation in the coming year will likely be fully consistent with the ECB’s target of below but close to 2%Y/Y, with core inflation significantly above the euro area average too.

With euro area economic growth stronger and inflation higher, and the Federal Reserve’s tightening cycle underway, some observers might expect the ECB similarly to become more hawkish and adjust policy itself should the positive trends intensify. However, last month the Governing Council appeared to pre-set monetary policy for the whole of the coming year, extending its QE programme from April to year-end at a rate of asset purchase of €60bn per month over that period, only slightly lower than at present. In addition, it restated that it expects its interest rates to be maintained at current levels or below well past the horizon of the QE programme, i.e. until 2018 at the earliest. But might policymakers soon have a change of heart?

Certainly, some members of the Governing Council might feel uneasy about the extended timeframe of the current policy commitments. And criticism of the central bank seems bound to rise further not least in Germany, where, with real interest rates now extremely negative, policy looks incongruous. But the ECB has to set policy for the euro area as a whole, not just for its largest member state. And, at the aggregate level, it will be several months at the earliest before any clear upward trend in core inflation might be identified with confidence.

Moreover, just as there are upside risks to the economic outlook, the ECB needs no reminding that there are also plenty of downside risks, which arguably also justify a continued dovish stance. Indeed, while the outcomes of elections this year in Germany, France, the Netherlands and (if it is called early) Italy currently might be expected to result in broadly market-friendly (if in most cases weak) governments, the tail risks of a triumph for Le Pen in France or the Five Star Movement in Italy, which could have grave economic and financial consequences, cannot be ignored.

Therefore, the ECB seems likely to stick to its guns and carry out its QE plans in full throughout 2017. If events pan out as forecast, or even exceed expectations, in the autumn Draghi will likely signal his intention to reduce further the asset purchases from the start of 2018, perhaps eventually to zero. And over the near term, as a sign that the debate surrounding its monetary policy has shifted, the ECB ought to amend its forward guidance, retracting its signal that its policy rates might be cut further. But, while the Fed Funds Rate looks set to be hiked again this year, Draghi certainly won’t be following suit. 

*This article was originally written for and published in Japanese by NNA Europe (http://europe.nna.jp)

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