Having raised expectations in earlier weeks for a forceful policy response, the European Central Bank (ECB) underwhelmed markets with the announcement following its 3 December meeting. While it cut rates and announced additional asset purchases, markets delivered the equivalent of a rate hike. The euro appreciated, bond yields rose, spreads widened and stock prices fell.
What happened? The ECB cut the interest rate on the deposit facility by 10 basis points to -0.3% as expected; however, the size of additional asset purchases arguably disappointed. The ECB extended the monthly asset purchases of €60 billion by six months to “the end of March 2017, or beyond, if necessary, and in any case until the Governing Council sees a sustained adjustment in the path of inflation consistent with its aim of achieving inflation rates below, but close to, 2% over the medium term.” (Read statement here.)
Somewhat inconsistent with this statement, the ECB lowered its inflation forecast for 2016 and 2017 by 0.1 percentage points to 1% and 1.6%, respectively. And interestingly, ECB President Mario Draghi said these forecasts would have been half a percent lower in 2016 and one-third of a percent lower in 2017 had additional measures not been implemented. If today’s market levels persist, however, these inflation forecasts might have to be revised down further.
Today’s combination – some additional stimulus, lower inflation forecasts and tighter financial conditions – sends a less-than-reassuring signal about the ECB’s ability to re-anchor inflation expectations. Effectively the ECB is signaling two things: It is uncertain whether it can achieve its inflation target over the forecast horizon (reminiscent of the Bank of Japan), and it is reluctant to undertake the degree of policy action the market deems necessary to do so. Only time will tell whether the ECB or the market is right.
We see the investment implications of today’s events as broadly unchanged. Duration in the middle of the government bond yield curve and credit should benefit from ongoing easing. While the market’s initial response is negative, tighter financial conditions serve to suppress the medium-term path for inflation. Ultimately the eurozone needs easier, not tighter, monetary conditions to return the economy to equilibrium. Today’s market reaction makes the path to economic recovery more challenging. The ECB left QE2 open-ended. March 2017 may therefore not be the end.