Policymakers at the European Central Bank (ECB) will be convening in Frankfurt on Thursday afternoon, their first monetary policy meeting so far in 2018.
Expectation that the ECB could begin raising interest rates in the Eurozone for the first time since 2011 this year were ramped up following the release of the bank’s latest set of meeting accounts in mid-January. The minutes were more hawkish than the market had anticipated. Officials had a ‘widely shared’ view that a gradual and careful shift to a less accommodative monetary policy would be appropriate, noting that ‘as progress was made toward a sustained adjustment in the path of inflation, the relative importance of the forward guidance on policy rates would increase’.
Given the recent shift to a moderately more hawkish stance, some investors expect that the ECB’s meeting on Thursday could shed some light as to the timing of the first interest rate hike in the bank’s main rate in almost seven years. However, we think it is unlikely that the central bank will shift its forward guidance at this juncture. The central bank has repeatedly reiterated that interest rates will remain low ‘well beyond the horizon of asset purchases’. With the central bank’s quantitative easing programme scheduled to run until at least September 2018, we think that it is far too early for the bank to begin discussions on the need for higher rates in the Eurozone.
The main concern for the central bank will be the subdued level of inflationary pressure in the currency bloc. Core inflation in the Eurozone remained stuck at just 0.9% in December (Figure 1), still comfortably below the central bank ‘close to, but below’ 2% target level. As we have mentioned on a number of occasions in recent months, we think that the ECB will need to see a more sustained upward trend in the rate of core inflation before it even considers altering its main policy rate. The release of a report last week citing ECB sources also raised the bar for a dovish surprise. The report suggested that fundamental changes to the central bank’s guidance was not likely this week, with the bank’s March meeting cited as a possibility.
Figure 1: Eurozone Core Inflation Rate (2013 - 2017)
Source: Thomson Reuters Datastream Date: 23/01/2018
We therefore expect no change in policy from the European Central Bank this week and President Mario Draghi to deliver a fairly neutral message that will call for ‘patience’ in policy and temper expectations for an interest rate hike in 2018. Despite a general improvement in economic data in the past few months, President Draghi may also be reluctant to issue an overly upbeat assessment of the Eurozone economy in an effort to prevent another sharp upward move in the Euro.
The common currency has strengthen by around 6% since November, a rally that has seen the currency rise to its highest position against the US Dollar in over three years. In our view, the latest rally in the currency has been overdone, and with net long Euro positioning stretched to an all-time high level, there is scope for a reversal that would pressure the EUR/USD rate lower.