EUR/USD

When the Governing Council of the ECB meets this week, it will be facing a less favorable growth outlook, no signs of core inflation trending higher and nervous financial markets. The truce between the US and China will buy time but does not fundamentally ease trade concerns, while in Italy the situation remains fragile with sovereign spreads still very wide and the economy flirting with recession. Recently, the only unambiguously good news has been the sharp drop in oil prices, mainly supply-driven, which will contribute to supporting eurozone economic activity in the coming months at a time of intensifying downside risks.

This assessment is likely to be reflected in a more cautious tone by ECB President Mario Draghi and in the ECB’s updated macroeconomic forecasts, which will probably show a downward revision to GDP growth for 2019 and 2020 from 1.8% and 1.7%, respectively, to somewhere in the 1.5-1.7% range. The latest data have confirmed that the ECB’s projections for core inflation remain too optimistic; the possibility of a further slight downward revision there, together with lower oil prices at the cut-off date, pose downside risks to the inflation forecast for the next two years, which currently stands at 1.7%. Numbers for 2021 will be published for the first time and they will probably show GDP growth settling at about 1.5% (broadly in line with the estimated potential growth rate of the economy) and inflation at 1.7-1.8%. It should be considered that some of the recent slide in oil prices occurred after the cut-off date used to determine the exogenous inputs to the ECB’s models. Therefore, the new forecast numbers will not fully reflect the scale of the correction in oil prices.

Despite the assessment turning less favorable, the Governing Council is very likely to call an end to its net asset purchases, reflecting the progress made so far in boosting economic growth, closing most of the output gap and stimulating wage formation. With the risk of outright deflation sharply reduced since the inception of QE and with technical constraints increasingly biting, an emergency tool such as net asset purchases is rightly regarded as having run its course.

However, financial conditions will have to remain very accommodative. Therefore, the ECB will probably take the opportunity to enhance its reinvestment guidance, at least by clarifying the timeframe for rolling over maturing assets. The current generic wording, that reinvestments will be carried out “for an extended period of time” after the end of net purchases, might be replaced with a statement suggesting that reinvestments will last for at least two years after QE is terminated – as a reference, the Fed’s full reinvestments lasted for three years after the end of their QE. The ECB’s chief economist Peter Praet recently noted that the market expects reinvestments to continue for two-to-three years. We doubt any change in the ECB’s guidance will challenge this expectation.

Liquidity support to banks will be another topic up for discussion this week, although our gut feeling based on the latest statements by Governing Council members is that an announcement might not come yet. We think the ECB will ultimately decide to extend TLTROs, probably by two years, at a less-favorable, variable interest rate. The rationale behind this extension would be twofold: first, it would allow the ECB to avoid a liquidity “cliff effect” as the residual maturity of outstanding TLTRO money starts to fall below one year in mid-2019, with negative consequences for banks’ net stable funding ratio. Second, it would support the transmission mechanism of monetary policy by easing funding stress for Italian banks.

Given how important timely guidance on liquidity policy is for banks’ funding plans, if the ECB does not make an announcement on Thursday, it will probably not wait any later than March 2019. If Draghi signals his determination to preserve the transmission mechanism of monetary policy, this should be read as an indication that action on liquidity is in the pipeline.

Easing growth and weak core inflation raise the risk of a bold dovish change in the rate guidance, for example one that pushes the timing of the first rate hike from after next summer into 2020. We see a 25% probability of this happening on Thursday.

Federal Reserve Vice Chairman for Supervision Randal Quarles said that interest rates are approaching neutral, but the concept of neutral rate can be less useful after the economic conditions become more normal.

Fed officials estimate the neutral rate of interest is from 2.5 to 3.5%, according to Quarles. Asked if Powell meant rate hikes would end sooner rather than later, Quarles said it was not clear about exactly how much further interest rates would rise.

"Where we will end up in that range will depend on the data we receive and our assessment of the performance of the economy over the course of next year," he noted.

Neutral interest rate, a notion that is driving the Federal Reserve' s attitude towards the normalization of U.S. monetary policy, means a level neither stimulative nor restrictive to the economy.

"I think that it can be a useful concept in helping guide monetary policy, but it's not terribly precise," Quarles said.

It may be changing over time, and "its utility as the central organizing thought around how you are conducting monetary policy becomes less."

"Because we are nearing other time where and we're moving back into a normalize monetary policy, that what's really important is that the Fed Reserve have a clearly communicated strategy, about monetary policy and that we execute on that strategy in a way that's predictable and transparent," said the Fed official.

The remarks came after Jerome Powell, chairman of the Fed, said last Wednesday that interest rates are "just below" the broad range of estimates of the level that would be neutral for the economy. Market participants interpreted that as a dovish signal for future rate hikes, compared with his previous remarks in early October that rates were "a long way" from neutral.

Fed raised its benchmark interest rate for the third time this year on September 26 and made the target range between 2% and 2.25%. At that time, Fed policymakers indicated another hike in December, three more in 2019 and probably one more in 2020.

Eurozone CPI amounted to 2% yoy in November, down from 2.2% the previous month.

The main reason behind the fall appears to be a waning boost from energy prices. On an annual basis, they were up 9.1% against 10.7%. On Thursday, U.S. crude briefly fell below $50 a barrel for the first time this year. Just a couple months ago, it was trading at four-year highs around $75 a barrel.

Despite the fall, headline inflation remains more or less where the European Central Bank would like it - its policy aim is just below 2%.

But stripping out volatile items like energy, inflation is much weaker and that's likely to concern the ECB. The so-called core rate fell to 1% from 1.1%, which suggests that wages increases are not strong enough to push up prices on a broad basis.

Despite the declines, the ECB is still expected on December 13 to end its monetary stimulus program, under which it has since 2015 bought government bonds in the markets to keep interest rates low. It has indicated it could start raising interest rates again next year, though not before the autumn at the earliest. The ECB has kept its main interest rate at zero for years and has a negative rate on deposits that commercial banks hold at the central bank.

The cooling eurozone economy was reflected in separate figures showing a modest 12k rise in unemployment in October to 13.17 million. Though that wasn't enough to raise the unemployment rate from the decade-low of 8.1%, it suggests that the consistent improvements of the past few years may be fading.

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