Flash Note Euro area: monetary policy

FLASH NOTE Flash Note Euro area: monetary policy ECB: the courage not to act Pictet Wealth Management - Asset Allocation & Macro Research 27 April 2017 The ECB left policy and forward guidance unchanged at today s meeting notwithstanding the increasingly solid recovery and diminished downside risks to the outlook. Our impression is that there is a strong consensus to finish the job by keeping the monetary stance very accommodative until the ECB sees signs of life in core consumer prices. Two important features of the ECB s communication will likely be adjusted in the next few months: the balance of risks to the economic outlook and the sequencing of policy normalisation embedded in the forward guidance. The former should move to neutral in June. The latter could be adjusted step-by-step in June and September. Still, the risk of market overreaction to any exit signal will likely remain elevated. We continue to expect a slow tapering of QE to start in Q1 2018, the deposit rate to be hiked in June 2018, and proper rate normalisation cycle to start very slowly in H2 2019. With the first round of the French election behind us and the euro area recovery becoming increasingly robust and broad based, one would have expected the ECB to feel more comfortable about adjusting its communication. Yet the Governing Council (GC) decided to leave its policy stance and forward guidance unchanged notwithstanding the increasingly solid recovery and diminished downside risks to the outlook. Our impression is that there is a fairly strong consensus within the GC to finish the job. The ECB is in no rush to embark on policy normalisation and rightly so in our view, as long as underlying inflation dynamics remain subdued. The central bank s key argument remains that the projected return of inflation to its 2% target still depends on a very substantial degree of monetary accommodation. As a result, no hard decision will probably be made until the long-awaited upward adjustment in core inflation becomes visible in the data, as described in Draghi s four inflation criteria. First, core inflation needs to move from around 0.9% (as measured by the ECB s less volatile super core gauge) towards the 1.1-1.2% level. Second, it needs to stay there, or rise a little further, for the adjustment to be self-sustained. Chart 1: ECB s super core inflation rate 3.5 3.0 2.5 2.0 1.5 1.0 % y-o-y ECB's 'super core' inflation rate (excluding package holidays) 0.92 AUTHOR Frederik DUCROZET fducrozet@pictet.com +41 58 323 4582 Pictet Group Route des Acacias 60 CH - 1211 Geneva 73 www.pictet.com 0.5 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16 17 Source: Pictet WM AA&MR, ECB, Eurostat The long road to neutrality, tapering and rate hikes Two important features of the ECB s communication will likely be adjusted in the next few months: the balance of risks to the economic outlook, and the sequencing of policy normalisation embedded in the forward guidance. The

latter was left unchanged, with policy rates still expected to remain at present or lower levels for an extended period of time, and well past the horizon of [the ECB s] net asset purchases", according to today s statement. The former was tweaked only at the margin, with the GC noting that the risks surrounding the euro area growth outlook, while moving towards a more balanced configuration, are still tilted to the downside and relate predominantly to global factors. This line of communication is similar to the one used by the GC in the past, including in June 2016 (ahead of the Brexit vote) and in April 2015 (after QE was launched). Meanwhile the assessment of the global recovery was upgraded, too, from somewhat stronger to stronger. The slight changes in wording are tracked in the appendix. Our view remains that the ECB has embarked on a very prudent and datadependent fine-tuning of its communication since the March 2017 policy meeting, when Draghi indicated that downside risks had become less pronounced. Today s changes to the statement merely shifted the balance of risks closer to neutral. Moreover, although the bias for lower policy rates was kept in March, the reference to rate cuts as a policy instrument was removed, with the sentence by using all the instruments available within [the GC s] mandate dropped from the statement, suggesting that QE expansion would be the ECB s preferred tool if it needed to act again. Since then, however, several GC members have pushed back against the market s hawkish interpretation of the March press conference. President Mario Draghi, Vice-president Vitor Constancio and the ECB s chief economist Peter Praet, in particular, have made a strong case for a very prudent approach to policy normalisation, urging no change to the sequencing between QE and rate hikes at this stage. Our understanding is that the lessons from past communication faux-pas have been learnt, taking into account the market s (over-)sensitivity to any exit signal as well as painful episodes such as the 2011 rate hikes or the 2013 taper tantrum. Still, when the time comes to open a proper debate on exit from unconventional measures, the risk of market overreaction will likely be elevated, especially if expectations remain relatively dovish. Looking ahead, our scenario remains unchanged (see ECB: escape the (NIRP) room, 21 March 2017): we expect the ECB to move to a neutral policy stance at the 8 June meeting in Tallinn, including a mention that risks to the economic outlook remain balanced and a removal of the bias for lower policy rates. In June, it might be too early for the ECB to introduce a distinction between the main refinancing rate (which is applied to openmarket operations, currently at 0%) and the deposit rate (which applied to banks overnight deposits, currently at -0.40%), in order to allow for a oneoff, technical adjustment in the latter before the end of QE. As a first step, the GC could tweak the forward guidance again in June, for instance by signaling a shorter period of time between tapering and rate hikes, from well past to some time after the horizon of net asset purchases. Either way, a modest improvement in the outlook for inflation, as we forecast, should be enough for the ECB to reassess the exit sequencing in the second half of this year. At this stage, we feel comfortable with our call for a deposit rate hike in June 2018, with risks skewed towards an earlier rate hike but with an extension of the QE programme well into 2018, in our view. 27 April 2017 FLASH NOTE - Euro area: monetary policy PAGE 2

Proper normalisation of ECB policy rates will only start in H2 2019, according to our central scenario. Chart 2: composite PMI and changes in ECB policy rates 50 bp Change in the ECB's refi rate (deposit rate from 2015) Euro area composite PMI (rhs) 64 25 0 60 56 52-25 -50 48 44 40-75 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16 17 36 Source: Pictet WM AA&MR, ECB, Markit 27 April 2017 FLASH NOTE - Euro area: monetary policy PAGE 3

Parsing the ECB: how the statement changed, and what to expect in the next few months The table below highlights changes between the ECB s March and April 2017 statements. Introductory statement to the press conference Frankfurt am Main, 27 April 2017 Main changes from previous meeting (9 March) Ladies and gentlemen, the Vice-President and I are very pleased to welcome you to our press conference. We will now report on the outcome of today s meeting of the Governing Council, which was also attended by the Commission Vice-President, Mr Dombrovskis. Based on our regular economic and monetary analyses, we decided to keep the key ECB interest rates unchanged. We continue to expect them to remain at present or lower levels for an extended period of time, and well past the horizon of our net asset purchases. Regarding non-standard monetary policy measures, we confirm that our net asset purchases, at the new monthly pace of 60 billion, are intended to run until the end of December 2017, or beyond, if necessary, and in any case until the Governing Council sees a sustained adjustment in the path of inflation consistent with its inflation aim. The net purchases will be made alongside reinvestments of the principal payments from maturing securities purchased under the asset purchase programme. Our monetary policy measures have continued to preserve the very favourable financing conditions that are necessary to secure a sustained convergence of inflation rates towards levels below, but close to, 2% over the medium term. Incoming data since our meeting in early March confirm that the cyclical recovery of the euro area economy is becoming increasingly solid and that downside risks have further diminished. At the same time, underlying inflation pressures continue to remain subdued and have yet to show a convincing upward trend. Moreover, the ongoing volatility in headline inflation underlines the need to look through transient developments in HICP inflation, which have no implication for the medium-term outlook for price stability. No change to the ECB s forward guidance, including the bias for lower rates or the exit sequencing (QE tapering first, then rate hikes well past the horizon of net asset purchases. We expect both to be adjusted in June. A more positive assessment of growth conditions as the recovery becomes increasingly solid and risks have further diminished. No change to the assessment of the inflation outlook as core prices have yet to show a convincing upward trend. A very substantial degree of monetary accommodation is still needed for underlying inflation pressures to build up and support headline inflation in the medium term. If the outlook becomes less favourable, or if financial conditions become inconsistent with further progress towards a sustained adjustment in the path of inflation, we stand ready to increase our asset purchase programme in terms of size and/or duration. Let me now explain our assessment in greater detail, starting with the economic analysis. Euro area real GDP increased by 0.5%, quarter on quarter, in the fourth quarter of 2016, following a growth rate of 0.4% in the third quarter. Incoming data, notably survey results, bolster our confidence that the ongoing economic expansion will continue to firm and broaden. The pass-through of our monetary policy measures is supporting domestic demand and facilitates the ongoing deleveraging process. The recovery in investment continues to benefit from very favourable No change. Dovish stance, including asymmetric bias to increase QE, still justified by the fact that higher inflation depends on a very substantial degree of monetary accommodation. Taking stock of recent positive activity data, the ECB s more positive assessment remains based on strong business surveys, the pass-through from monetary measures, improving job conditions as well as signs of a stronger global recovery (compared with somewhat stronger in the 27 April 2017 FLASH NOTE - Euro area: monetary policy PAGE 4

financing conditions and improvements in corporate profitability. Employment gains, which are also benefiting from past labour market reforms, are supporting real disposable income and private consumption. Moreover, the signs of a stronger global recovery and increasing global trade suggest that foreign demand should increasingly add to the overall resilience of the economic expansion in the euro area. However, economic growth continues to be dampened by a sluggish pace of implementation of structural reforms, in particular in product markets, and by remaining balance sheet adjustment needs in a number of sectors. The risks surrounding the euro area growth outlook, while moving towards a more balanced configuration, are still tilted to the downside and relate predominantly to global factors. Headline inflation has been recovering from the very low levels seen in 2016, largely owing to higher energy price increases. After reaching 2.0% in February 2017, euro area annual HICP inflation stood at 1.5% in March. This reflected mainly lower energy and unprocessed food price inflation, but also a decline in services price inflation. Looking ahead, on the basis of current futures prices for oil, headline inflation is likely to increase in April and thereafter to hover around current levels until the end of this year. However, as unutilised resources are still weighing on domestic wage and price formation, measures of underlying inflation remain low and are expected to rise only gradually over the medium term, supported by our monetary policy measures, the expected continuing economic recovery and the corresponding gradual absorption of slack. March statement). Another subtle change to the balance of risks ( moving towards a more balanced configuration ), which should become explicitly neutral in June. Inflation expected to have passed its peak, and to hover around current levels until the end of this year. No change to the ECB s broader assessment on the so-called four criteria. Turning to the monetary analysis, broad money (M3) continues to expand at a robust pace, with an annual rate of growth of 4.7% in February 2017, after 4.8% in January. As in previous months, annual growth in M3 was mainly supported by its most liquid components, with the narrow monetary aggregate M1 expanding at an annual rate of 8.4% in February 2017, unchanged from the previous month. The recovery in loan growth to the private sector observed since the beginning of 2014 is proceeding. The annual growth rate of loans to nonfinancial corporations declined to 2.0% in February 2017, from 2.3% in the previous month, while the annual growth rate of loans to households remained broadly stable at 2.3% in February. At the same time, the euro area bank lending survey for the first quarter of 2017 indicates that net loan demand has increased and bank lending conditions have further eased across all loan categories. The pass-through of the monetary policy measures put in place since June 2014 continues to significantly support borrowing conditions for firms and households and credit flows across the euro area. A slightly more upbeat assessment of credit flows based in particular on the latest Bank Lending Survey. To sum up, a cross-check of the outcome of the economic analysis with the signals coming from the monetary analysis confirmed the need for a continued very substantial degree of monetary accommodation to secure a sustained return of inflation rates towards levels that are below, but close to, 2% without undue delay. Fine-tuning, but no significant change. 27 April 2017 FLASH NOTE - Euro area: monetary policy PAGE 5

In order to reap the full benefits from our monetary policy measures, other policy areas must contribute much more decisively to strengthening economic growth. The implementation of structural reforms needs to be substantially stepped up to increase resilience, reduce structural unemployment and boost productivity and potential output growth. Regarding fiscal policies, all countries should intensify efforts towards achieving a more growth-friendly composition of public finances. A full and consistent implementation of the Stability and Growth Pact and of the macroeconomic imbalances procedure over time and across countries remains crucial to enhance the resilience of the euro area economy. We are now at your disposal for questions. Notice: This marketing communication is not intended for persons who are citizens of, domiciled or resident in, or entities registered in a country or a jurisdiction in which its distribution, publication, provision or use would violate current laws and regulations. The information, data and analysis furnished in this document are disclosed for information purposes only. They do not amount to any type of recommendation, either general or tailored to the personal circumstances of any person. Unless specifically stated otherwise, all price information is indicative only. No entity of the Pictet Group may be held liable for them, nor do they constitute an offer or an invitation to buy, sell or subscribe to securities or other financial instruments. The information contained herein is the result neither of financial analysis within the meaning of the Swiss Bankers Association s Directives on the Independence of Financial Research, nor of investment research for the purposes of the relevant EU MiFID provisions. All information and opinions expressed in this document were obtained from sources believed to be reliable and in good faith, but no representation or warranty, express or implied, is made as to its accuracy or completeness. Except for any obligations that any entity of the Pictet Group might have towards the addressee, the addressee should consider the suitability of the transaction to individual objectives and independently assess, with a professional advisor, the specific financial risks as well as legal, regulatory, credit, tax and accounting consequences. Furthermore, the information, opinions and estimates in this document reflect an evaluation as of the date of initial publication and may be changed without notice. The Pictet Group is not under any obligation to update or keep current the information contained herein. In case this document refers to the value and income of one or more securities or financial instruments, it is based on rates from the customary sources of financial information that may fluctuate. The market value of financial instruments may vary on the basis of economic, financial or political changes, currency fluctuations, the remaining term, market conditions, the volatility and solvency of the issuer or the benchmark issuer. Some investments may not be readily realizable since the market in the securities can be illiquid. Moreover, exchange rates may have a positive or negative effect on the value, the price or the income of the securities or the related investments mentioned in this document. When investing in emerging countries, please note that the political and economic situation in those countries is significantly less stable than in industrialized countries. They are much more exposed to the risks of rapid political change and economic setbacks. Past performance must not be considered an indicator or guarantee of future performance, and the addressees of this document are fully responsible for any investments they make. No express or implied warranty is given as to future performance. Moreover, forecasts are not a reliable indicator of future performance. The content of this document can only be read and/or used by its addressee. The Pictet Group is not liable for the use, transmission or exploitation of the content of this document. Therefore, any form of reproduction, copying, disclosure, modification and/or publication of the content is under the sole liability of the addressee of this document, and no liability whatsoever will be incurred by the Pictet Group. The addressee of this document agrees to comply with the applicable laws and regulations in the jurisdictions where they use the information reproduced in this document. This document is issued by Banque Pictet & Cie SA. This publication and its content may be cited provided that the source is indicated. All rights reserved. Copyright 2017. Banque Pictet & Cie SA is established in Switzerland, exclusively licensed under Swiss Law and therefore subject to the supervision of the Swiss Financial Market Supervisory Authority (FINMA). Distributors: Banque Pictet & Cie SA, Pictet & Cie (Europe) SA 27 April 2017 FLASH NOTE - Euro area: monetary policy PAGE 6