The European Central Bank not only makes its decision (where no change is expected) but also releases new staff forecasts for growth and inflation. This makes the March 9th decision an important one. With the latest inflation figures for February already out, it’s time to analyze the big event that will hopefully move the euro out of its recent range.
Since the beginning of the year, inflation has bounced quite sharply. This is due to energy prices and the diminishing base effect. Oil prices were at their trough in early 2016, and this is the reason for elevated yearly prices rises now. In February, headline inflation reached the round 2% level, the holy grail of central banking.
The ECB and especially President Mario Draghi had anticipated the rise, but the more hawkish members of the Governing Council want the ECB to tackle headline inflation, which reached the ECB’s target of 2% or a bit below. Germans are “allergic” to inflation, due to the extreme hyperinflation that was seen in the Weimar Republic.
Draghi is likely to focus on Core CPI, which is not going anywhere fast: 0.9% once again. On the other hand, other measures such as growth, employment, and business confidence have been rising. The economic recovery is picking up speed and this implies higher core inflation down the road.
Two factors for Draghi
The keys to the euro reaction depend on two factors: if forecasts are revised to the upside and Draghi’s tone regarding inflation.
Back in December, inflation forecasts were hardly changed, implying further stimulus. Will they change their mind now? The European Central Bank does not change its forecasts easily, at least not for future years: 2018 and 2019. Any upgrade of long-term inflation implies a need to act sooner rather than later. For 2017, the ECB could be forced to increase its projections, but could also do it reluctantly.
Draghi would prefer to keep the euro low and not to talk about tapering or ending QE. A weaker euro pushes inflation higher and assists exports. The ECB currently buys 80 billion euros per month, but the amount will be reduced to 60 billion from April and set to run until the end of the year.
Time is on his side: the ECB announced the extension of its QE program in December 2016, three months prior to its planned expiry date. If we follow the same logic, the Frankfurt-based institution is likely to make an announcement only in September, with speculation running high over the summer. In any case, there is a lot of time.
So, Draghi could opt to acknowledge the improvement and even the acceleration in economic activity while postponing any talk about future policy to a future date. To counter any optimistic words, the Italian could reiterate that monetary stimulus is still very much needed. Accommodative policy, or lower for longer, will not be absent from the script or from the questions to answers.
EUR/USD reaction
The ECB is no longer the only game in town. We have seen how political events have rocked markets with Brexit, Trump and now with opinion polls related to the French elections. Nevertheless, the ECB remains the most powerful institution moving the common currency.
Upgraded forecasts and a spoken acknowledgment of the upbeat data will boost the euro while a cautious outlook and seeing a glass half empty on core inflation (in order to keep the euro depressed) will depress the euro.
We will probably get a mix of both. In that case, markets will digest the messages from Draghi and will eventually pick a direction. Will Draghi get his way in pushing down the euro? It works in more cases than not, but it is far from a sure thing. He also had his share of failures.
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