ECB Needs To Build A Macroeconomic Narrative To Justify Upcoming Tapering

ECB's upcoming taperingEuropean Central Bank

Draghi’s speech in Sintra central bankers summit triggered some excitement yesterday morning because he argued that a central bank, which does not change its policy amid improving cyclical conditions, is, in effect, loosening its stance, thus implicitly opening the door to some tightening. BoAML’s analysts think it is not a surprise. “Rather than engaging in a “hawkish festival”, we think we should pay attention to the very prudent tone he maintained throughout, “they explain.

Tapering will come anyway, largely because of technical/ political constraints around QE. The ECB will still have to justify this with a macroeconomic narrative. This is what the ECB President has set out to do. However, experts believe that what he said yesterday is also consistent with a very slow exit.

In particular, with a growing decoupling between QE — now increasingly presented as an emergency tool — and policy rates, which could well stay “low for long”, because a key message from the ECB is that, while deflation risks have abated, inflation normalization (back to “below but close” to 2%) will take very long.

Conditions changed compared to three years ago

Draghi insisted ‎on the idea that QE was triggered by a sense, three years ago, that the Euro area was at risk of a negative spiral, with cyclical deterioration becoming entrenched and possibly taking potential GDP growth down, with the output gap thus closing “in the wrong direction”. This called for a monetary stance bringing the economy onto a sounder footing “without undue delay”. The situation has changed now, with a central bank confident that cyclical conditions have brightened and deflationary spirals have become much less ‎likely. Emergency action is thus much less necessary.

But, at the same time, Draghi has taken pains to show that a full normalization of inflation is still far away, pointing at the deteriorating quality of the jobs being created, impeding wage growth, a succession of negative external shocks (such as commodity prices)‎ and some measure of low inflation hysteresis (expected inflation is affected by years of sub-par observed inflation, as investors and economic agents, in general, “get used” to low consumer price growth).

Prudent retreat – and low rates for long. We stick to our call

This got Draghi to his usual point that a substantial quantum of monetary policy support is warranted (“we have to be persistent”) and that any change in policy parameters needs to be gradual (and prudent). This increasingly points to the notion that focus is going to gradually shift away from QE — what you do when risks abound — and more towards policy rates — what you do “for the long haul”. At the end BoAML concludes:

This we think strengthens our point (made in our note last week) that, while QE is tapered, forward guidance on rates (low for long) will remain. We reiterate our policy call: we expect the ECB to prepare the grounds in September to announce in October that QE will be scaled back from the current EUR 60bn/month to EUR 40bn for six months (Jan-Jun18), followed by faster tapering in 2H18. When QE ends in Dec-18, we expect a one-off technical hike in the deposit rate.