ECB to remain cautious on policy despite inflation pick-up

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This Thursday’s meeting of the European Central Bank (ECB) in Frankfurt is shaping up to be a major event risk in the currency markets. 

At the ECB’s July meeting, the overall tone of the bank’s statement, and indeed Draghi press conference, was fairly dovish. He highlighted the need for policymakers to remain “persistent” and “patient” with existing stimulus measures while acknowledging ongoing economic expansion has yet to translate into stronger inflation dynamics.

Currency traders instead latched onto his comment that discussions on the QE programme would take place “in the autumn”, stoking speculation that Draghi would use the September meeting to announce a tapering of asset purchases. This would involve a reduction in the amount of monthly assets that the central bank currently purchases below the existing 60 billion Euros level.

Economic conditions in the Eurozone seem to point to the need for discussions on tighter policy. The Eurozone economy expanded at its fastest annual pace since 2011 in the second quarter. Unemployment was unchanged in July and is now also at its lowest level since February 2009, which should continue to filter its way through to foster stronger growth. Headline inflation jumped unexpectedly to 1.5% year-on-year in August from 1.3%, its highest level since April (Figure 1). The core measure, which excludes volatile components of unprocessed food and energy and is watched closely by the ECB was, however, unchanged again at just 1.2%.

Figure 1: Eurozone Inflation Rate (2013 - 2017)

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Source: Thomson Reuters Datastream Date: 01/09/2017

Despite the obvious improvement in economic conditions in the Eurozone, the Governing Council for its part has continued to emphasise the need to maintain a loose monetary policy. In its latest accounts it claimed that a convergence in inflation towards target “would only come gradually and remained conditional on a substantial degree of monetary accommodation”. Draghi himself also struck a fairly cautious tone at his appearance at the Jackson Hole conference in Wyoming at the end of August. It is clear to us that policymakers in the Eurozone are in no immediate rush to alter policy. As we have been saying for a number of months, we think we would need to see a more sustained rebound in core inflation back towards the ECB’s “close to, but below 2%” target before it announces a tapering in the QE programme is on the way.

Policymakers will also no doubt be wary of recent Euro strength and there is also now growing speculation that Draghi will comment on the strength of the common currency in an attempt to calm the market reaction and put a short term cap on its recent appreciation. The Euro has had a remarkably impressive 2017 so far, appreciating by close to 15% for the year and briefly breaking above the physiological 1.20 level versus the US Dollar for the first time since January 2015 (Figure 2). We’ve also seen a rather dramatic reversal in Euro shorts positioning. The ECB has previously alluded to its preference for a weaker currency and we wouldn’t be surprised to see Draghi making some form of reference to the exchange rate during his conference.

Figure 2: EUR/USD vs. EUR/USD Net Positioning (September ’16 - September ‘17)

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Source: Thomson Reuters Datastream Date: 01/09/2017

We think there is a good chance the European Central Bank could disappoint the market at its meeting this week. Still below target inflation and a lofty Euro by recent standards means we expect a slightly more cautious statement that would leave the door ajar to a more significant announcement on policy at the next meeting in October. In our view, risks to the Euro are skewed to the downside. A failure of Draghi to at least hint at the possibility of a winding down in stimulus measures may lead to a decent-sized sell-off in the common currency, particularly given the very high bar set by the market following the July meeting.

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