European Central Bank turns a dovish hue

The European Central Bank (ECB) caught up with the Eurozone’s evolving reality of slowing growth and easing inflation.
Radhika Rao08 Mar 2019
  • The European Central Bank’s policy has taken a dovish turn
  • GDP growth and inflation forecasts have been cut to underscore concerns over the outlook
  • A fresh round of funding have been rolled out, while QE reinvestments continue
  • Rates will be on hold for rest of the year, along our expectations
Photo credit: AFP Photo

The European Central Bank (ECB) caught up with the economy’s evolving reality of slowing growth and easing inflation. With growth falling below the post-quantitative easing quarters and inflation likely to follow suit, the central bank opted to frontload measures. Importantly this contrasts with the decision to cease QE two months back.

The ECB’s tone was cautious. They expressed fears that the economy might remain stuck in a "period of continuous weakness and pervasive uncertainty" this year. Staff GDP forecasts were cut sharply – growth is now seen at 1.1% in 2019, 1.6% in 2020 and 1.5% in 2021. This compares to December’s outlook for growth at 1.7% in 2019 and 2020. They retained the guidance that risks to the growth outlook are “still tilted to the downside”, owing to geopolitical uncertainties (including Brexit), protectionist threats and slowing emerging markets.

Despite this, the ECB holds on to expectations that the slowdown will be temporary and improve in 2H19, pointing to a strong labour market, better loan growth, higher fiscal spending and easing domestic idiosyncratic factors, that particularly hurt German industrial activity last year.

Inflation forecasts were also lowered – now seen at 1.2% in 2019, 1.5% in 2020 and 1.6% in 2021. This compares with 1.6% for 2019 and 1.7% for 2020 in December. Core inflation forecasts were lowered by 20bps across this year and next. A concurrent revision in underlying oil price assumptions also underscored their benign view on cost-push forces. This inflation outlook suggests that the ECB expects inflation to remain below the target even in the medium-term.

Source: ECB, DBS Group Research

This cautious economic assessment was accompanied by four measures, few new while others reaffirmed their policy bias.

- The forward guidance on rates was changed to “interest rates will remain at their present levels at least through end-2019”, from the earlier “through the summer of 2019”. Separately, the ECB chief suggested that few of the Council members backed a pause into March 2020

- ECB will continue to reinvest proceeds of bonds maturing under the just-concluded QE program, “in full” and “for an extended period of time”.

-New round of Targeted Longer-term Refinancing Operations (TLTROs-III) were unveiled, starting in September 2019 and ending in March 2021. These will be rolled out quarterly, based on the main refinance rate (not the deposit facility rate) and with a two-year maturity. Further details will be announced closer to the date. These will help preserve favourable lending conditions and ensure transmission of an accommodative monetary policy. The previous two rounds of TLTROs were announced in 2014 and 2016.

- The existing ECB lending operations will continue as fixed rate tender procedures with full allotment at least until March 2021.

Policy outlook: Yesterday’s measures were not a big surprise, but the timing of the announcement was. The decision to be ahead-of-the-curve was likely a step to reverse any unwarranted tightening in financial conditions. Policy normalisation plans are on ice (see here), with no rate hikes likely beyond the ECB President Draghi departure from office in 4Q this year. In fact, this marks the only instance when the head of the central bank ends his tenure without any rate hikes.

While the funding support might cap any increase in funding costs, it does not alleviate the main risks for the Eurozone outlook, i.e. external developments – overhang of US auto tariffs, slowing global growth particularly in China, and Brexit developments. This also suggests that any severe downturn in the second half of the year might necessitate new and unexplored policy responses.

The ECB’s dovish turn pushed the EUR/USD decisively below the pre-normalisation trading range of 1.15-1.25, along the expectations of the DBS Currency FX Strategist. The next target at 1.10 beckons.

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Radhika Rao

Economist – India, Thailand & Eurozone

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