Monetary pillar crumbles
19 June 2018
In the early years of the European Central Bank (ECB), it targeted a reference value for growth of the M3 broad monetary aggregate of 4.5% under its "monetary pillar". The role of the monetary pillar was significantly downgraded after 2003, and the price stability target formally defined as "below but close to 2%", as money growth picked up but with little information content about inflation. So the ECB is unlikely to be perturbed by the recent slowdown in M3 growth (see Chart 6), which in any case is partly a consequences of declining net asset purchases. Growth of the narrow monetary aggregate M1 is a better, although still far from perfect, leading indicator of activity growth, and it too has slowed in recent months. But this has to be set against the decent rate of credit growth and upbeat bank lending surveys. Overall, monetary aggregates look consistent with our forecasts of moderating but still above-trend growth and a very gradual re-emergence of inflation pressures.
The ECB itself broadly agrees with that assessment, and last week announced its intention to taper its net asset purchases over the course of Q4, ceasing purchases by the end of this year. Expectations for the tapering announcement coming at this meeting or in July were more-or-less equally split, although the June announcement was not a huge surprise after ECB Chief Economist Peter Praet's recent hints. The dovish chaser to the tapering announcement was 'enhanced forward guidance' on policy rates, with the ECB stating its intention to keep rates on hold "at least through the summer of 2019". The precise meaning of "at least through the summer of 2019" was the subject of a number of questions at the press conference, but President Draghi refused to be drawn on exact timing. We think it's reasonable to see this language as consistent with our own forecast of an initial rate hike in September 2019, although the risks are skewed to an even later hike. The market certainly took enhanced forward guidance dovishly, with the euro weakening, and both European bond and equity markets rallying.
These policy moves are predicated on the ECB's forecasts for growth and inflation, laid out in the staff macroeconomic projections. Despite the recent softness in the activity data, the ECB's view remains that there is underlying strength in the Eurozone economy. So while the 2018 GDP forecast was lowered to 2.1%, the 2019 and 2020 forecasts were left at a still-above-trend 1.9% and 1.7% respectively. These activity forecasts are now very similar to our own, but where the ECB differ from us is in its upbeat inflation forecasts (see Chart 7). The ECB thinks that a "sustained adjustment in the path of inflation" is now in train. Partly that's a result of the recent rise in oil prices, but the ECB also thinks that the ongoing reduction in spare capacity will feed through powerfully to higher core inflation. We are less convinced, and expect the trade-off between dwindling slack and higher inflation to remain fairly flat over the next few years. So while the ECB is forecasting headline inflation of 1.7% in each of the next three years, our own forecast is for 1.7% in 2018 but then 1.5% and 1.4% in 2019 and 2020 respectively, as oil base effects drop out. The upshot is that, while we expect rate rises to begin towards the end of next year, the pace of tightening is likely to be very gradual.