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No end in sight for ECB’s ultra-loose policy

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The major event last week was the ECB’s decision to extend QE to September next year, at the reduced rate of €30 billion per month from the end of this year – down from the current figure of €60 billion. At the post-meeting press conference, Mario Draghi stuck to his mantra that rates would stay low for some time after the end of QE, but also promised to extend the QE programme or even increase the monthly amount again, should economic conditions justify such action.

Despite the fact that Draghi has been fairly steadfast in his dovishness for some considerable time, the markets were apparently surprised by his words and proceeded to sell the euro hard. Against the dollar in particular, the single currency had a rough ride last Thursday and Friday, dropping some two and a half cents.

Not even strong eurozone PMI data could support the euro – and they were strong, with manufacturing coming in at a stellar 58.6 against expectations of 57.8. Services disappointed a little at 54.9, against expectations of 55.6, but that still represents healthy growth. There is currently much debate as to whether the recent strong economic data emanating from the eurozone represents a permanent improvement on account of the threat of deflation having been banished – or whether it is merely a cyclical upturn that could easily be expected to follow the cycle and turn downwards again in due course. As is so often the case, the answer is ‘a bit of both’.

All over the world, the threat of deflation is receding and this should come as no surprise, given the enormous amounts of quantitative easing effected by the central banks of the eurozone, US, Japan and UK. China’s stimulus packages have been harder to quantify – but substantial nonetheless. If one prints money and pushes it into the system via QE, despite the inefficiencies in the programmes – largely as a result of commercial banks’ propensity to hang on to cash – some of the extra liquidity will work itself into the broader economy. Indeed, this has been the case. Unfortunately, the same liquidity has also kept afloat ‘zombie’ companies which should have been allowed to go the way of all flesh and this has adversely affected global productivity growth – but this is a story for another time.

As the global deflationary forces have subsided, so the ECB’s stimulus packages have taken on the appearance of being ever less contra-cyclical in nature. Indeed, the casual observer might easily be forgiven for thinking that, in light of the recent positive growth data from the eurozone, the ECB, having only last week kept rates at emergency levels and announced an extension of its asset purchase programme, has started to act pro-cyclically. After all, Draghi announced that asset purchases would be extended to September 2018 – albeit at €30 billion per month, half the current rate – and would be extended again, and even increased, should economic conditions so dictate. This point is so crucial that it bears repetition.

Draghi, however, has his eye on inflation and will not be pushed off-track by a growth rate of 2.5% which may be cyclical, given the strength of the global economy, with even Japan posting six consecutive quarters of expansion – the best unbroken run for more than a decade. Indeed, yesterday’s announcement that the annualised rate of increase in core eurozone CPI is running at only 0.9% should be a flag to the markets that there is potential for plenty more accommodative policy. It has of late become almost a truism that central bankers regard inflation to be a lesser evil than unemployment, and with eurozone headline inflation still running at just 1.4% there is still much to be done on this front - not least in Draghi’s homeland of Italy, where core inflation still languishes at just 0.5%.

Interestingly, at last week’s post council meeting press conference, Draghi opined that risks to the euro area growth outlook remain “broadly balanced”, adding that “downside risks continue to relate primarily to global factors and developments in foreign exchange markets.” There could be no clearer indication that the ECB president intends to put a cap on EUR/USD after the exchange rate’s surge so far this year. The more than 12% appreciation in the euro has been unhelpful in bringing inflation back to the target of ‘close to but below’ 2%.

Yesterday’s inflation numbers were weaker than expected, but had little impact on interest rates, with three and five year swap rates both moving up a basis point to -0.15% and -0.11% respectively. EUR/USD was also becalmed and trades at the time of writing at 1.1637. It seems that Draghi’s underlying concerns continue to be vindicated and he is, correctly, not being swayed by the recent encouraging growth data which may yet turn out to be cyclical in nature.   

Outside the Spanish markets, the recent events in Catalonia have made little impact. With Madrid having called elections in Catalonia for December, the separatists have been somewhat wrong-footed. With the Catalan government dissolved and Carles Puigdemont having temporarily disappeared (and then re-surfaced in Brussels), the ousted leader may be hoping for some support from the EU. In this, though, he is certain to be disappointed, since the EU cannot tolerate any dissent when it comes to unity - as the difficult Brexit negotiations so amply demonstrate.

 

All views expressed here are the author’s own and are based on information available at the time of writing.

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