ECB loose policy messages favour undervalued Euro

Intermoney | The all powerful German union IG Metall is demanding the creation of a 10 Bn€ fund for the component providers of the German car industry to facilitate the transition to electric vehicles. The resources would come equally from the German government and German carmakers and would offer financing at 1.5% over 6 or 6 years to the most solvent. Details which remain secondary given the reality of the downside risks to the Eurozone, including Germany, which explain initiatives like this.

This situation coincides with the Bundesbank´s more prudent tone on the German economy, which has been reinforced recently and which, “coincidentally”, preceded Draghi´s words pointing clearly to further stimuli. According to the ECB president, those responsible for monetary policy in the Eurozone will discuss in the next few weeks how to deal with the deterioration of economic activity in the Eurozone.

The reality, as Draghi points out, is that the situation needs governments to undertake structural reforms, even if this does not avoid the ECB again having to act as the “fireman”. The president of our central bank recalled the “considerable margin for manoeuvre” for measures like asset purchases, as long, we would add, as the limits are re-examined with a view to dealing with the debt situation in Germany.

Beyond our scepticism about the ability of new stimulus measures to drive the economy, we recognise that the ECB is obliged to act which will create a situation unfavourable for its inflation targets. In this scenario, we consider that the reactivation of asset purchases with certain adjustments (based on the reality of German debt) would be the measure with the greatest positive impact, more so than interest rate cuts. Nevertheless, if the second path is explored, it would be accompanied by measures to mitigate the effect of negative rates on the banking sector.

In short, Draghi´s messages were clear and direct:

“We will us all the flexibility within our mandate to fulfil it, and we will do so again to respond to any challenge to price stability in the future” and “monetary policy remains committed to its targets, and will not accept inflation that is too low”. That said, the intensity of the possible action is as important as the will to act and this could be measured given that Draghi again downplayed the importance of market inflation expectations: “some of these market based indicators of inflation expectations have lost a certain inflation content due to technical conditions which have affected these markets, especially recently”.

In practical terms, the ECB is responding to the weakening of activity in the Eurozone and an outlook dominated by risk, especially to German industry, as we highlighted in our last weekly report. The main risks which overshadow the future of the Eurozone are linked to the ramifications of the trade tensions created by Donald Trump, and which could sink into a dangerous vicious circle.

The US President has trade relations with the Eurozone in his sights, but this question has been put aside until the second half of the autumn in the hope that, by then, he will already have secured a trade victory over China. The problem is that the Chinese will not give way to the Americans and seek an aesthetic agreement, although the president of the Asian giant is willing to meet Trump during the G20 and, secondly, that it does not believe that this will serve to revive trade negotiations. Thus we Europeans find ourselves in the worst of all situations, given that Trump will try to gain a major trade victory at our expense, and the increase of the Eurozone´s trade surplus (January – April) from 46 Bn€ in 2018 to 48.2 Bn€ in 2019 will only increase the pressure.

On the other hand, what is certain is that the ECB´s loose policy messages should play in favour of the undervaluing of the euro, which will be another key variable in the adjustment to promote an improvement of activity in the Eurozone. Currently, based on purchasing power parity and the inflation figures, the euro is 3.55% undervalued compared to the dollar and this scenario should continue, which will also lead Trump to keep the euro in his sights. In fact, although the ECB meeting in Sintra was already programmed, Draghi´s message just before a Fed meeting, in which a more generous tone or guidance has been discounted, was not coincidence.

The Federal Reserve does not want to be seen as responsible for the end of the current expansionary cycle in the US and this, together with political and market pressures, makes it fairly likely that it will end up taking a backward step in the near future. In practical terms, today will see a narrative which will allow confidence in preventive adjustments like those in 1995 and 1998. In fact, the current scenario will force the Fed to perform a difficult balancing act, given that the current US economic situation does not require stimuli, while the economic risks arising from Trump´s international policies oblige it to open the door to greater generosity. Unfortunately, this situation could lead to another vicious circle.

Confronting this, it will be even more important how the Fed sees the future and this will make the market focus on the FOMC´s updating of its forecasts for the US economy, in concrete official rates. As for the GDP and employment forecasts for the last quarters of 2019-2021, no great changes are expected from those in March. Then the members of the FOMC pointed to an increase of 2.1% in GDP for the end of 2019 and 1.9% at the end of 2020, while the unemployment rate will increase progressively from 3.7% in 2019 to 3.9% in 2020. Which would not prevent unemployment rates remaining very low, below the 4.4% usually associated with full employment.