Flash Comment ECB preview: Still pressure from low inflation

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1 Investment Research General Market Conditions 8 January 2014 Flash Comment ECB preview: Still pressure from low inflation Euro inflation has declined again and core inflation is at an all-time low. This adds pressure on the ECB to ease further, but we expect it to refrain from cutting rates at the meeting in January, even though it is likely to discuss a deposit cut. Core inflation at an all-time low Inflation expectations have continued its downward trend since the latest refi rate cut in November and as this is the main concern for the ECB we expect Mario Draghi to be dovish and signal that he is ready to act to ensure inflation expectations remain well anchored. Looking ahead, deflation is not a prerequisite for more ECB action. If inflation stays below 1% for some time, it may be enough to entail further easing. In our view, the ECB is likely to ease monetary policy further in April due to a new drop in inflation and core inflation. This is a close call. While inflation will stay below 1% for some time, the growth outlook is expected to improve and in the periphery the widespread improvement in sentiment appears more robust. Source: Eurostat and Danske Bank Markets Falling commodity prices still expected to keep inflation low in If more action is needed, a deposit cut seems to be the preferred tool at the ECB, but as this measure has both advantages and disadvantages any hints on other measures should be followed closely. We do not believe much is priced in for this week s meeting in terms of rate cuts or LTRO announcements. In our base case, Draghi will sound dovish and this should probably be enough to keep rates in check for the time being. Low core inflation adds pressure on the ECB The pressure on the ECB to ease again remains as core inflation has hit an all-time low of 0.7% and headline inflation declined to 0.8% in December. Last month Draghi said inflation excluding food and energy drifts slightly higher over the forecast horizon and the drop in core inflation clearly adds pressure on the ECB. Nevertheless, we do not expect more easing at the meeting on Thursday, but we do expect Draghi to be dovish. Looking ahead, deflation is not prerequisite for more action, in our view. If inflation stays below 1% for some time, it may be enough to entail further easing from the ECB. This is supported by a comment from Draghi given on 30 December, where the message was that inflation below 1% is considered dangerous. The second serious risk is that inflation, which is already clearly below our 2% target, might fall further. Yet we aren t seeing any deflation, i.e. a general fall in prices. But we must be very careful that we do not permanently fall below 1% inflation and thus into the danger zone. As long as inflation stays below 1% the ECB has a credibility problem if it does not act and if this continues the ECB is likely to act to ensure that inflation expectations remain well anchored. We expect the ECB to ease again in April and a deposit cut seems to be the preferred tool at the ECB (see below). Further easing should follow as the inflation figure for March is expected to show a decline to 0.6% from 0.8% in January and February. The decline should also be seen in core inflation and is due to the timing of Easter. Market-based inflation expectations continue to decline Senior Economist Frank Øland Hansen franh@danskebank.dk Analyst Pernille Bomholdt Nielsen perni@danskebank.dk Analyst Anders Vestergård Fischer afis@danskebank.dk Important disclosures and certifications are contained from page 4 of this report.

2 If the ECB allows inflation to be too far away from its objective without acting, it runs the risk that inflation expectations go down. Low inflation expectations are the main concern for the ECB and as the market based inflation expectations is still on a downward trend after the latest refi rate cut in November, it is another argument for Draghi to be dovish. The ECB is expected to stay on hold at the meeting on Thursday and Draghi will probably repeat that it takes time for the full effects of the monetary policy to materialise Moreover, he could reiterate that the ECB s policy is not determined on the basis of a single figure for inflation and that the latest decline in core inflation to some extent is due to methodological changes to some subcomponents in German inflation. There is a risk that these comments will be interpreted as hawkish as was the case at the December meeting, where it seemed that Draghi was a bit annoyed about the pressure for more easing already. But it might also be that he sounded more defensive that intended and that he will be more careful this week. Hence, we see the upside risk to rates as limited. A firmer recovery leaves the ECB in a dilemma Whether the ECB will ease more in the future is a close call, especially as the latest survey data continue to confirm the euro area recovery is gaining momentum. Soft indicators in the periphery have improved and the widespread improvement in economic sentiment appears more robust. German business surveys also continue to strengthen and point to GDP growth in the area of 3-4% q/q annualised in the first part of This leaves the ECB in a dilemma with a better outlook for growth while inflation is expected to stay below 1% for some time. Even though it is not clear the ECB will act symmetrically around its inflation target, we expect it to defend its mandate if inflation stays low for a long period even though the growth outlook continues to get better. Decline in core inflation partly due to technical change in German sub-index The recovery leaves the ECB in a dilemma Monetary development still a concern Another dilemma for the ECB, which is likely to increase as rates stay low, is that asset bubbles could materialise, which would pose a threat to financial stability. Draghi has mentioned this risk, but on 30 December he said Until now, however, we have only seen significant price increases in some specific and limited markets. Hence, so far this does not seem to be a concern, which would keep the ECB from its accommodative policy. On the other hand, the latest data for monetary development continue to show that the easy monetary policy is not feeding through to credit growth. This is currently a downside risk to the growth outlook, and a concern for the ECB, but we do not expect immediate action. The ECB will probably wait for data that can give a first assessment of whether banks are more willing to lend out in 2014 after the snapshot of their balances has been taken at the end of If bank lending starts to improve, this would be a third argument for the ECB not to ease further even though inflation will remain below the target. A deposit cut still seems to be the preferred tool at the ECB The ECB is likely to discuss a deposit rate cut, like it did in December, but we expect it to refrain from cutting further at the meeting in January. The ECB has other options, but a deposit cut seems to be the preferred tool. At the meeting in November Draghi said, referring to negative deposit rate, that we are technically ready and it is part of our artillery, and in a sense it also answers the previous question about what we will do if we see a low rate of inflation. At the December meeting the Governing Council briefly discussed a deposit cut, whereas Draghi did not seem particularly keen about a new LTRO and also sounded sceptical about embarking on quantitative easing. Negative deposit rate still seems to be the preferred tool at the ECB Since such an instrument has both advantages and disadvantages and as it previously seemed that the bar for implementing a negative deposit rate was very high any softening 1.60% 1.40% 1.20% 1.00% 0.80% 0.60% 0.40% Pricing EUR-OIS 1m swap 0.20% 2 8 January % Jan14 Jul14 Jan15 Jul15 Jan16 Jul16 Jan17 Jul17

3 on other measures will be followed very closely at the meeting in January. For more on the other options at the ECB, see ECB preview: More stimulus, but not in December. Market expectations Judging from where the markets are trading, we do not believe much is priced in for this week s meeting in terms of rate cuts or LTRO announcements. The EONIA forward curve is very flat up to one year and is kept in check by a combination of the declining excess liquidity (due to LTRO repayments) and the commitment to continue the full allotment procedure in the main refinancing operations (MROs) at least until July Hence, any liquidity accidents to push up money market rates significantly is avoided as we also saw over the turn of the year with plenty of excess liquidity in the system. Not much is priced in for the meeting Pricing EUR-OIS 1m swap 1.60% 1.40% 1.20% 1.00% 0.80% 0.60% 0.40% 0.20% 0.00% Jan14 Jul14 Jan15 Jul15 Jan16 Jul16 Jan17 Jul17 7-Jan-14 Current policy rate Next policy move Source: Danske Bank Markets With unchanged wording in forward guidance and no new signalling of available policy measures we should expect a muted market reaction following the press conference. In our base case, Draghi will do little else but sound dovish, which should probably be enough to keep rates in check for the time being. We would probably need a new round of pressure (e.g. inflation below 1% for some time) for the markets to build expectations of further ECB action. 3 8 January

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