On Monday, the ECB’s Chief Economist Philip Lane gave a speech. Given the timing, so soon after the September policy meeting, it was no doubt crafted as an opportunity for the ECB to clarify its message in light of the market reaction. It is the Governing Council’s chance to either validate or correct the market’s response to the new policy measures.
In the conclusion, he said “Forward guidance on the key ECB policy rates is a very powerful instrument and remains our principal tool, together with the level of our key policy rates, for adjusting the monetary policy stance.” This speech was attempting to clarify the ECB’s position even further, to stop markets from swinging their expectations wildly ahead of each policy meeting.
There were two sections to the speech: the economic environment; and the ECB’s monetary policy response to it in the September meeting. The first was nothing new – trade disruption is weakening the global economy, the manufacturing sector is slowing but services and the labour market have not yet been hit.
The second section, on the ECB’s response, had a number of significant points:
- Inflation target: “a clarification of our reaction function: our determination to act when inflation falls short of our medium-term inflation aim is just as strong as our determination to act when inflation exceeds that aim.”
This appears to be a response to those who suggest that the ECB would allow inflation to “run hot” to compensate for the lengthy period of sub-target inflation we currently inhabit.
- Negative rates: “Negative rates have supported the portfolio rebalancing channel of the asset purchase programme (APP) by encouraging banks to lend to the broad economy instead of holding onto liquidity.”
This is a re-emphasis that the ECB views negative interest rates as an effective tool, and that they have a positive impact on bank lending – perhaps in response to those that ask whether negative interest rates are actually hindering, not helping.
- Further rate cuts: “We judge that, if needed, we can further lower the deposit facility rate and, with it, the overnight money market rate. As a result, there is no reason for the distribution of future short-term rate expectations to be skewed upwards.”
This is fairly self-explanatory, but confirms to the market that they won’t be seeing any upward surprises in the near future, and the effective lower bound is not here yet.
- QE: “we are confident that the envisaged purchase volumes will be consistent with the current parameters of the APP for an extended period of time.”
We have on this very blog questioned whether the €20bn Asset Purchase Program figure is a realistic upper bound, and the ECB is responding (though perhaps not specifically to us) that they don’t expect QE to exceed this level. The ECB thinks they have time and headroom, but that will run out within six to nine months.
- Forward Guidance: “The phrase “robustly converge” means that the Governing Council wants to be sure that the process of convergence is sufficiently mature and realistic before starting to lift policy rates. The qualification that convergence needs to be “consistently reflected in underlying inflation dynamics” means that the trajectory of realised inflation should underpin our inflation outlook.”
This is, in my opinion, the key point. He says that before policy rates can rise, and before QE can again be wound down, not only do inflation expectations have to rise, but realised inflation needs to follow those expectations. This stresses that the ECB needs to see actual, sustained inflation growth before rates will rise again – reducing fears of over-tightening killing any nascent recovery.
So if you’re looking for the potential pain trade from here, taking this speech into account, it would be where the trade tariffs cause more harm to the industrial sector and the weakness spills into services and the labour market. Underlying inflation stays depressed, and the ECB cuts rates further and lifts the ISIN limits on government purchases.