The long journey to European Central Bank (ECB) policy normalisation continues in baby steps. The ECB left policy unchanged but acknowledged that the risks to the growth outlook are no longer “tilted to the downside” and that it does not foresee cutting interest rates over the medium term. This is eminently sensible – the ECB could neither credibly look the market in the eye and deny the improvement in the macroeconomic picture, nor claim that an interest rate cut might be needed soon.
The ECB’s own analysis, however, suggests that a large part of the European recovery has been down to its policies so there will be no rush to unwind its accommodative stance. The low inflation forecasts and, arguably, the looming issue of Italy’s debt sustainability, allows the doves to win the battle in the governing council and keep the €60bn/month bond purchase programme going. Indeed, just in case the market believed that the ECB was becoming overly hawkish, the statement reminded the market that the quantitative easing (QE) programme can be expanded and that interest rates will stay at the current level “well past” the end of QE.
The market took its cue from these warnings, and the low inflation forecasts, and interpreted the ECB’s message as very dovish. Strong growth, low inflation and an accommodative central bank creates a very positive backdrop for European risk assets.
The real test comes next year when the ECB hits its legally-binding issue limit for German bonds – at that stage, the ECB could be forced to end purchases regardless of the prevailing macroeconomic environment. We believe that growth will continue, and broaden, but that we are a long way from seeing wage-induced inflationary pressure. The experience of other developed markets suggests that labour doesn’t have the wage bargaining power ordinarily expected at this stage of the cycle.
How the ECB handles the issue limit constraint when inflation is still below its target will be the key question for markets over the coming months.