Next week's European Central Bank meeting is going to be a double balancing act for President Mario Draghi and his colleagues.
How will the ECB get round a pretty basic conundrum? On the one hand, the ECB wants to prepare financial markets for tapering, without creating a ‘taper tantrum’. On the other hand, in a world without inflationary pressure, the ECB will have to substantiate the tapering preparation with economic arguments that do not leave market participants completely stumped: a balancing act that requires all of Draghi’s verbal acrobatic skills.
The general macro picture in the Eurozone has not changed since the ECB’s early June meeting. Confidence indicators remain strong, despite some recent downward corrections. Activity has picked up further, but inflationary pressures are almost impossible to find. If anything, the drop in oil prices, the pickup in bond yields and the strengthening of the euro have further (at least technically) deteriorated the ECB’s inflation outlook.
More generally speaking, the ECB will continue facing very little home-made inflationary pressures.
There are reasons to believe that wage growth in the Eurozone is bound to stay lacklustre.
Slack in the labour market and sectoral and technological changes all argue against a fast pick-up in Eurozone wage growth, even with GDP growth above trend growth. In addition, digitalisation, as long as it continues to increase in importance in B2B and B2C, is likely to apply downward pressure on consumer prices due to higher price transparency and more competition, now also in services.
Evidently, given bond market developments of the last two weeks, the ECB’s macro assessment will not be the main item on next week’s meeting agenda. A possible unwinding, or tapering, of QE is on the top of the mind of every market participant and ECB watcher. We believe that, given the cyclical upswing, the disappearance of deflationary risks, opposition to QE from some ECB members and the bond supply scarcity issue, the ECB wants to move towards tapering. However, the ECB ideally would like to prepare markets without distorting them.
In this process of moving towards tapering, the absence of any inflationary pressure makes the narrative a bit complicated. This is why Draghi tried to adjust the official communication and line of argumentation away from inflation and towards a new concept of a monetary policy ‘speed limit’. In this context, the key phrase in Sintra, Portugal, was: “As the economy continues to recover, a constant policy stance will become more accommodative, and the central bank can accompany the recovery by adjusting the parameters of its policy instruments – not in order to tighten the policy stance, but to keep it broadly unchanged”; the ideal new narrative for the ECB to prepare to taper.
In our view, the ECB’s ‘tiptoeing’ towards tapering will continue and we expect Draghi to repeat the key messages from the Sintra speech next week. Particularly, however, the reaction of bond markets over the last two weeks was a good reminder of how thin the line is between preparing markets and distorting them. Though some steepening of the yield curve is fine, a real ‘taper tantrum’ is not. This is why some dovish remarks by Draghi should not be excluded. The best way to do this would be by stressing the sequencing, ie, by dropping clear hints that a first interest rate hike will not come before the end of QE.