Macro Vision June 13, 2017 ECB: The tricky road to monetary policy normalization The Euro Area growth has improved, but inflation needs time to catch up. This scenario allows the ECB to recognize that risks have improved and move to a neutral stance. Looking ahead, the ECB s exit strategy will need to be gradual, carefully executed, and clearly communicated. We expect the central bank to eventually announce and implement, starting in 2018, a simultaneous exit, with QE tapering and the removal of negative interest rates. In our view, this exit sequencing, which is different from the current forward guidance given by the ECB, allows the central bank to gradually remove accommodation while maintaining financial conditions in the periphery at adequate levels. The commitment to reversing the tapering process if economic conditions deteriorate will continue to be emphasized, as strong negative market reactions could trigger another euro debt crisis. Stronger growth, but inflation needs time to catch up The Eurozone economic recovery is firming up and is well anchored in domestic demand. One of the main reasons for the excessive ultra-loosening monetary policy undertaken by the European Central Bank (ECB) following 2012 s Eurozone crisis was the weak state of the Eurozone s economy, which contracted 0.9% that year. After a solid 1.7% GDP growth in 2016, activity indicators have continued to pick up, with the recovery being driven by domestic demand (which tends to be less sensitive to external shocks). The Eurozone PMI, a leading growth indicator, is at its highest level since April 2011 (see below the chart on the left). Unemployment has been falling and is set to pressure core inflation ahead. Eurozone unemployment has fallen from a 12.1% high in April 2013 to 9.3% as of April 2017. The recovery in activity data is mostly a consequence of stimulus from the ECB and structural reforms undertaken in many European countries, which takes some pressure off governments and limits the need for extreme austerity measures. Additionally, a lower unemployment gap generates wage pressures and contributes to an increase in underlying inflation, core CPI (see below the chart on the right). 2% 1% Eurozone PMI at its strongest level since 2011 index 65 60 55 3. 2.5% Lower unemployment to pressure core prices ahead Core CPI YoY 6m Lagged Unemployment (rhs - inverted) 6% 7% 8% 50 9% -1% 45 1-2% GDP (qoq, lhs) Composite PMI (rhs) -3% 30 Jun-99 Jun-02 Jun-05 Jun-08 Jun-11 Jun-14 Jun-17 Source: Haver, Itaú 40 35 1999 2002 2005 2008 2011 2014 2017 Source: Haver, Itaú 11% 12% 13% Please refer to the last page of this report for important disclosures, analyst and additional information. Itaú Unibanco or its subsidiaries may do or seek to do business with companies covered in this research report. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should not consider this report as the single factor in making their investment decision.
Inflation is set to hit the ECB target by 2019. As commodity prices stabilize, the headline inflation measures tend to slowdown in the coming months. However, as core prices build up based on labour market tightening, inflation should pick back up by 3Q17 and then slowly gravitate towards the ECB target of below but close to 2% (see chart). This allows the ECB to gradually prepare markets for its monetary policy changes in order to keep volatility to a minimum. 3.5% 3. 2.5% Inflation outlook to play into ECB s strategy of calming markets yoy CPI Core ECB CPI ECB Core - - - Target 0. Forecast - - 2010 2011 2012 2013 2015 2016 2017 2018 Source: Haver, ECB, Itaú Political risks are now more symmetric, but is still an issue. Following Emmanuel Macron s election as France s President, and the ensuing Franco-German cooperation, political risks in Europe are now more symmetric, although is still an issue, as discussed in our previous work on Europopulism (albeit tempered by the weak performance of anti-establishment candidates in recent regional elections). Given strong economic performance, the debate surrounding the Eurozone is now likely to shift towards how the ECB will exit its nonconventional monetary policy program, which involves Quantitative Easing (QE) measures as well as negative interest rates on excess deposits (currently at -0.4%) and keeping its main refinancing operations rate at 0. (the so called lower bound ). Below we discuss the main issues surrounding the ECB s Governing Council debates and what we believe is the most likely exit strategy. The entire scenario is conditional on no further euro breakup events over the forecast horizon! ECB exit needs to be gradual due to country-diversity within the Eurozone According to Chief Economist Peter Praet, the ECB believes that the unemployment gap should close sometime around 2019, implying that the ECB aims to achieve its target around the same time. In fact, many Eurozone countries are already facing a tightening of the unemployment gap (with the exception of, Greece and Cyprus see below the top chart). Nonetheless, sustainable inflation is not yet apparent across all Eurozone countries, as core CPI, which excludes the volatile energy and food components, is still very unevenly behaved (also on the same chart). Additionally, inflation must be self-sustained, so it could endure even without monetary policy stimulus. This is the question that seems to concern the ECB Governing Council. If stimulus removal comes too fast and is not well communicated, yield spreads between the periphery countries and the center ones tend to widen sharply, as they did in 2012 (see chart on the bottom left). And if spreads rise too fast, we may have another Eurozone debt crisis, with renewed concern about a euro break-up. How this breakup tantrum would occur matters little, but we expect the first focus to be on due to its high debt/gdp ratio, relatively weak productivity, financial and political system stresses and low potential GDP growth (see chart on the bottom right). Page 2
Greece Portugal Belgium Cyprus France Ireland Austria Slovenia Germany Netherlands Finland Malta Slovakia Lithuania Latvia Luxembourg Estonia Cyprus Netherlands Ireland Portugal Finland France Greece Malta Slovenia Eurozone Germany Belgium Luxembourg Slovakia Lithuania Estonia Latvia Austria Macro Vision June 13, 2017 0. - Unemployment gap closing in most Eurozone countries yoy Core CPI Unemployment (rhs) 25% 2 15% 1 5% - Source: Eurostat, Itaú 7 6 5 4 10Y Bond - Spread against Germany In pp 18 16 14 12 10 Eurozone Gross Debt/GDP by country 3 2 8 6 4 1 2 0-1 Jun-05 Jun-08 Jun-11 Jun-14 Jun-17 Source: Bloomberg, Itaú Source: IMF, Itaú ECB exit strategy: Negative rates go out first, then QE, then the lower bound. As we have discussed, the ECB needs an exit strategy that takes into account the idiosyncratic economic cycle differences amongst Eurozone member countries. In particular, this implies: A need to maintain stimulus in the periphery, without which their fiscal condition may become unsustainable. A need to recognize that central economies are at a more advanced adjustment phase of the cycle. Central countries like Germany, Luxembourg and Austria have been stepping up the pressure for stimuli removal, as QE and negative yields are damaging to these countries financial systems. Therefore, Mr. Draghi and his team need to gently guide markets towards exit, otherwise they risk triggering another euro debt crisis. Based on this, we have outlined what can be expected from the ECB in the timeline below. Page 3
1. First move is to change communication. By June 2017: Acknowledge that risks are balanced and that there is no need to continue committing to lower rates. By September/October 2017: Announce extension of QE program until end-2018 with a EUR 20-25billion taper, starting in January 2018. Signals discussion on order of exit. December 2017: Order of exit should be clear. Hawkish members of the board will pressure for a depo rate hike. 2. 2018: Implementation time. Bring the depo rate back to 0. (from -0.4%) with a 10-bp hike per quarter. Hikes to start in March 2018. Announce further QE taper for 2019 3. 2019: QE comes to an end in December. 4. 2020: Discussion on raising rates into positive territory. In sum, the rationale behind our view is a rather simple one: Periphery yields cannot go up significantly, otherwise we will have a new debt crisis; but central economies are doing fine. If the ECB continues using QE to artificially keep the periphery-center spreads subdued, it might be able to provide relief to banks and appease its hawkish members while supplying time for the structural recovery in the periphery to take place. Vitor Fonseca Ferreira Page 4
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