Saturday, November 27, 2010

ECB: Still in exit mode

ECB: Still in exit mode

  • After two relatively uneventful meetings, the ECB will unveil updated macroeconomic forecasts and will announce new steps on liquidity management on 2 December.
  • On balance, the projections for 2010-2011 should have a slightly more hawkish flavor, with the September forecasts being either confirmed or revised slightly higher.
  • However, the key numbers will be the ones for 2012. If the 2012 forecasts were to unveil CPI at 1.7%-1.8% and GDP growth at 1.6%-1.7%, as we expect, our call for a first refi rate hike at end-2011 would remain well on track.
  • On the liquidity front, despite some signs of resurfacing money market tensions, the ECB will probably stick to its plan to discontinue the full-allotment at 3M LTROs at the beginning of next year.

New forecasts: slightly more hawkish in 2010-2011, but the focus is on 2012
The updated CPI/GDP projections need to be monitored closely, as they will factor in recent strength in the euro and commodity prices, while providing for the first time numbers for 2012 – the latter having a very important signaling function. We expect the projections to validate our view that the first refi rate hike will be delivered at the end of next year.

Consumer Prices (in % yoy)
2010 2011 2012
December 2010 1.6 1.8 1.7-1.8
September 2010 1.6 1.7 ---
Real GDP (in % yoy)
2010 2011 2012
December 2010 1.7 1.4 1.6-1.7
September 2010 1.6 1.4 ---
Source: ECB, UniCredit Research

The inflation forecast for 2010 will be likely confirmed at 1.6%, while prospects for 2011 look a bit more uncertain. We think that the ECB may decide to include in its baseline scenario some of the upside risks envisaged in September and raise the 2011 projection from 1.7% to 1.8%, but we acknowledge that this is a close call. A slight upward revision would confirm that the net impact of the “side effects” of the Fed’s QE2 on eurozone CPI is going to be upwards, with higher commodity prices more than offsetting the drag stemming from currency appreciation. But the key CPI number will be the one for 2012, because it will provide the expected price developments on the policy-relevant horizon.

We think that the ECB will signal an inflation rate of 1.7%-1.8% –i.e. in line with its definition of price stability – with broadly balanced risks. A higher rate would be perceived as a hawkish signal, which could push the market to price in the beginning of a tightening cycle already in 1H 2011, while a rate of 1.5-1.6% (in line with the outcome of the last Survey of Professional Forecasters) would risk being seen by markets as a green
light to price out the 25bp rate hike currently discounted by the Euribor strip at end-2011. We doubt that the ECB will want to validate either one of these two scenarios: the former would pose a challenge in terms of further potential currency strength, the latter would probably leave several GC hawks uncomfortable. Going forward, changes in the balance of risks to the 2012 CPI forecast will be the main tool in the ECB’s hands to communicate to the markets its intention to start adjusting monetary policy.

Coming to GDP, the 2010 forecast should be raised from 1.6% to 1.7%. The 2011 projection will give an idea of the estimated growth impact of recent currency appreciation and higher commodity prices. Back in September, the central bank projected 1.4% GDP growth next year with slight downside risks, implicitly assuming that the euro nominal tradeweighted index (TWI) would remain constant throughout the forecast horizon at the level of 103.05 – the average of the ten trading days ending on the cut-off date of 13 August.

In the first two weeks of November, the reference period for the exogenous variables included in the December forecasting exercise, the euro TWI averaged 105.8. Mechanically, this 3% appreciation should shave 0.2pp off the ECB’s GDP forecast for 2011, with the largest impact likely to be felt in 2Q and 3Q next year. However, the surprisingly strong November PMIs showed that all the currency-related drag on the 2011 GDP average will probably be offset by a stronger growth performance in 4Q 2010 than the central bank had expected. Accordingly, the ECB should decide to leave the 2011 call at 1.4%, and we can’t rule out that this time they will signal balanced risks (back in September, downside risks prevailed). The forecast for 2012 will be at least as important as the one for 2011 but, in contrast to CPI, its interpretation won’t be straightforward, mostly because we don’t know exactly by how much the ECB has lowered its own estimate
of the area’s potential growth rate after the credit crisis. It’s quite likely that the ECB’s projections will envisage stronger GDP in 2012 than in 2011, but the implications for monetary policy of this acceleration crucially depend on where the central bank sees potential growth. Our working assumption is that they have in mind a 1.3%-1.5% range for the area’s cruising speed (probably more at the higher end): if we are right on this point, the ECB could decide to come up with a GDP forecast for 2012 of around 1.6%-1.7%. While not
particularly impressive, this growth performance should suffice to push the ECB towards the first rate hike at end-2011 if the bias for the recovery is to broaden and strengthen further – something that we do expect.

Liquidity strategy:
exit set to continue despite debt woes

Up to a few days ago, we were very confident that renewed tensions on peripheral countries’ spreads wouldn’t have stopped the ECB from announcing further exit measures on 2 December, namely the discontinuation of the full-allotment for 3M LTROs. After all, the most recent comments by central bank officials were clearly supportive of this view – Mersch even saw a growing risk of keeping rates too low for too long.

However, the outcome of the last 3M LTRO on Wednesday showed higher-than-expected bids (EUR 38bn vs. EUR 19bn expiring), consistent with the resurfacing of some tensions in the money market. While this is not enough to make us revise our expectations, we are now aware of the increased risk that next week the ECB will simply decide to change nothing on the liquidity front.

From a fundamentals perspective, our view remains well grounded. Apart from the last episode, excess liquidity in the system remains on a declining trend and central bank funding in the most troubled countries has started to decline (with the only exception being Ireland), so that discontinuing the full-allotment at 3M LTROs at the beginning of next year still makes sense. This is true particularly after the 3M Euribor climbed above the refi rate, thereby creating some distortions in the functioning of the interbank market at this tenor.

Moreover, as we have already pointed out recently, the upward trend in the 3M Euribor rate has tracked very closely the “fair” refi rate prescribed by our Taylor rule in response to some narrowing of the output gap and a moderate recovery in lending to the private sector.

This suggests that money market normalization is now fully justified by the improvement recorded both in the financial sector and the real economy, and we doubt that the ECB will miss the opportunity to further reduce the maturity of the liquidity injected into the system.

However, weakness in the financial sector of peripheral countries implies that the central bank will want to make the transition towards a pre-crisis liquidity provision framework as smooth as possible. Full-allotment is probably going to remain in place for 1M LTROs and, in all likelihood, for weekly MROs. In our baseline scenario, 1M LTROs are brought back to normal at the beginning of 2Q 2011, while the return to across-the-board competitive bidding occurs around mid-2011. Risks are skewed towards a slower normalization process, particularly if debt woes persist.
Full report: ECB: Still in exit mode

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