NN IP: The battle continues between ECB hawks and doves

Hawks and doves have different policy preferences

Back in October the ECB doves succeeded in keeping QE forward guidance open-ended, which preserved the link between the continuation of net asset purchases and progress towards price stability. Back then, we wrote that the doves had won the battle but not the war with the hawks.  Over the past few months, the hawks have in fact become more vocal, arguing for the ECB to announce as soon as possible that it will stop net purchases completely after September, even though Draghi previously ruled out such a hard stop. If they were to get their way, this could well lead to a tightening of financial conditions, even though the extent to which this happens would depend very much on how much dovish foam the ECB puts on the runway by tweaking other instruments (e.g. making rate guidance more state-dependent). 

The war between the doves and the hawks will thus continue this year and the stakes have become higher. First of all, even though the ECB slowed down the pace of QE, it can still claim that the link between its continuation and progress towards price stability is being preserved for now. However, scarcity and political constraints more or less dictate that the ECB stops net purchases in the not too distant future. The big question is then whether this can happen without the market concluding that the ECB has reneged on its forward guidance. What’s more, the end of QE will bring the start of the rate hiking cycle within investors’ planning horizon, because of which it may become more difficult for the ECB to manage rate hike expectations, especially if the disagreement between the hawks and the doves continues in the midst of important leadership changes within the governing council, including a new ECB president, by the end of 2019.

To assess where ECB may be heading in this respect, it is instructive to have a rough idea where it is today. Earlier on, we identified the asymmetric reaction function which produces a much more accommodative policy stance for any given pace of nominal growth as well as the degree of commitment in forward guidance as distinctive features of the current policy environment.  On both metrics the ECB actually performs very well.  When using German and French yields to create a synthetic EMU 10y yield, the ECB currently has achieved a pretty steady real 10y yield of around -100 bps over the past 2 years. On top of this, the ECB’s forward guidance contains a pretty large degree of commitment because it effectively rules out interest rate hikes before March 2019, assuming that QE ends in September and June 2019 if there is a soft taper in Q4.

In view of all this, one can understand why the hawks are getting increasingly uncomfortable with the level of the policy stance as well as the large degree of pre-commitment. After all, growth over the past year has consistently surprised on the upside while there has been a melt up in risk assets in the face of a range-trading German 10y yield while peripheral spreads have been reduced (i.e. the synthetic EMU 10y yield including all countries has declined on balance). All this clearly smells of an endogenous easing of monetary policy driven to some extent by a rise in r-star and to some extent by continued easing (which is what net asset purchases amount to). The only outlier in the group of circumstantial evidence here is the euro, which appreciated some 6% in trade-weighted terms. This is certainly not exclusively a dollar story. EM currencies and the yen have also played their part in this development. This does not really contradict the endogenous monetary-easing hypothesis, because the upside surprises to growth have arguably been the biggest in Euroland, while the degree of political uncertainty declined simultaneously. Both have been conducive to increased net capital inflows pushing the euro higher. Of course, the large EMU current account surplus may also have played a role here. In addition to these developments several hawks maintain a large degree of confidence in the Phillips curve, causing them to believe that a noticeable pickup in wage and price inflation will happen within the next two years given the speed with which the unemployment rate has been declining. Also, some hawks are not very concerned about low inflation, which they attribute to global and technological factors. Adding it all up, it is not surprising this minority group within the Council would like to speed up the exit journey somewhat.

By contrast the doves believe that sustainably attaining the inflation target and ensuring inflation expectations are firmly attached to it is a necessary condition for achieving an equilibrium with healthy nominal growth and higher equilibrium yields. While they do retain faith in the Phillips curve, they are probably also uncertain about the position of some key inputs of this relationship ,most notably the NAIRU and the level of inflation expectations. In particular, there may be more slack than the hawks believe and inflation expectations may well have fallen below the target.  As a result of all this, the doves would rather err on the side of being too cautious, also because moving too fast too soon could lead to a sudden tightening of financial conditions, which could materially slow nominal growth. If this were to happen it would force the ECB to remain lower for even longer (which is essentially what happened to Fed after the taper tantrum). These doves would obviously like to see some evidence of firming inflation pressures in the actual wage and inflation data. If anything, the latter have disappointed a bit over the past three months as core inflation fell back to 0.9% yoy while wage growth only shows very tentative signs of picking up from levels that are well below what is consistent with price stability.  Of course, the recent euro appreciation does not help in this respect because it may keep core inflation lower for longer. In an environment of well-anchored inflation expectations, this would not be a problem, but under the current circumstances, it could well contribute to cementing the latter more firmly at a below target level.

Balancing confidence with patience and persistence is tricky

How exactly the coming battles between the hawks and the doves will play out is really anybody’s guess. What is clear is that it will lead to some twists and tweaks to various instruments over the course of the year. The big underlying story here remains that the ECB will gradually de-emphasise the continuation of net asset purchases as its main instrument while putting more emphasis on other instruments, most notably rate guidance. The speed with which this rebalancing across instruments happens depends crucially on the degree of confidence in the inflation outlook. After all, only if that confidence is large enough the ECB can claim to have preserved the link between the continuation of QE and progress towards price stability. In a sense the compromise (or truce) between the hawks and the doves back in October was that QE open-endedness was agreed by the former in exchange for using confidence in the inflation outlook as a signal for the likelihood that net asset purchases will be terminated in the not too distant future.  In this respect, an important message to take away from the press conference is that this confidence remains on a rising trend. The ECB continues to be surprised on the upside on the growth outlook which translates into a higher probability that the Phillips curve mechanism will become stronger. In addition to this, the statement also made it clear that the ECB is no longer aiming for a further easing of financial conditions, something that was already apparent in the December minutes. The implication is clearly that out of the three QE options beyond September (continuation, taper and hard stop), an open-ended continuation has become the least likely. The choice will clearly be between a three-month phasing out or a big step towards zero. Most of the effect of this choice will be felt on market pricing of ECB rate hikes. A hard stop probably means a first rate hike in March.

Draghi had previously stated that a hard stop was not the ECB’s game plan but during the press conference, he more or less admitted this was a personal preference and that the Council had not yet agreed on this. Perhaps these remarks acted as an important driver for the strong euro appreciation that started during the press conference. Another reason may have been that Draghi felt obliged to continue to play by the rules of the international FX game even though the US administration had broken them earlier in the week when the US Treasury Secretary stated that “obviously a weaker dollar is good for us”. As far as efforts to talk down the currency go, one rarely gets to see a clearer example than this. In response Draghi was constrained by the agreement not to engage in competitive depreciations, which imply that central banks mostly refer to exchange rate uncertainty rather than levels. Still, without explicitly mentioning the US administration, he criticized them when he mentioned “use of language on exchange rates that is inconsistent with global agreements”. In addition to this, Draghi stated again that the ECB can live with endogenous euro appreciation (i.e., driven by growth differentials) but he also implied that exogenous appreciation would be resisted using monetary policy. To back up these words with action Draghi stated that the “well past” element of rate forward guidance was “fundamental” to ECB policy strategy. In addition to this he endorsed a statement by Weidmann earlier this month that market expectations for a first rate hike around the middle of 2019 are pretty reasonable.

All in all, the press conference and the market reaction to it was a textbook example of how tricky the balance is between signalling increased confidence in the outlook and maintaining patience and persistence in (expectations of) the monetary policy stance. The risk that the market will get ahead of itself and trigger an unwarranted tightening of financial conditions (mostly via the exchange rate) is indeed pretty big and we expect that this will not change in the near future. This risk, alongside the fact that inflation is still well below target (which may also hold for inflation expectations), should cause the ECB to err on the dovish side in an ideal world. The essential idea is to keep the money market curve very flat in the near future in order to allow it to steepen more in the more distant future. However, we do not live an ideal world. The ECB hawks and doves have different policy preferences, as a result of which their battle will continue. This makes it more difficult for market participants to extract policy signals. Our expectation for the ECB is still for a soft taper between September and December and a first rate hike in the middle of 2019, which should start a hiking cycle of roughly 50 bps per year. The risks to this outlook are now pretty balanced. A stronger nominal recovery could cause a hard stop and an earlier hike, but the aforementioned risk of the market getting ahead of itself could force the ECB to be lower for longer. As far as the near term is concerned, we expect some changes to the QE forward guidance in March, with the most likely replacement being that the policy stance in general will be made state-contingent. On top of this, “well past” could well be maintained until well into the summer to tame the money market curve and prevent excessive euro appreciation. At the June meeting, the ECB will probably announce the aforementioned soft taper.

Emerging markets: good-enough growth, benign inflation

Q1 economic data in EM is always difficult to read due to changing base effects linked to the Chinese New Year. This year will be no different. So before we enter this period, let’s look at where we stand.

On growth: for five months now we have been saying that although still positive, EM growth momentum is close to neutral, suggesting that growth in EM, on balance, is no longer improving. This is still the case. It has been good enough for the EM rally to continue, though. In the coming months we will probably not get any meaningful evidence of an improvement, but this will also work the other way around: the theme of good or reasonable EM growth is likely to last, as evidence of a deterioration should not come any time soon.

Looking a bit closer at the composition of growth in EM, we expect the past quarters’ trend of EM ex-China improving more than China to continue. For the coming years we expect Chinese growth to slow by half a percentage point annually, while the GDP-weighted average of the rest of the emerging world will improve by half a point per year. A key driver of this is credit growth, steadily slowing in China and rising nicely in EM ex-China.

Relevant here is EM monetary policy and financial conditions. Our proprietary indica-tors suggest that financial conditions remain easy, despite the rising bond yields in the US and Europe. Our EM monetary-policy-stance indicator is slightly positive, telling us that among all EM central banks, we currently have on balance more cutters than hikers. This is supported by inflation dynamics, which remain benign. The weighted-average EM CPI is 3.3% and is likely to remain below 4% in the coming year. In our forecasts, CPI will peak at 3.8% in Q3.