Dovish ECB stance masks hawkish policy message

Neil Dennis 16:03, 8 March 2018

How does one communicate an increasingly hawkish policy path in an utterly dovish manner? Step forward Mario Draghi, president of the European Central Bank, who delivered a masterclass in nuance at Thursday's February governing council press conference.

An escalation of trade wars would lead to greater political uncertainty and a weaker US dollar
by Phil McHugh, chief market analyst at Currencies Direct

Earlier on Thursday, the ECB kept its main policy settings on hold. The main repurchasing interest rate at zero, the deposit facility rate at -0.4% and maintaining its commitment to €30bn in monthly asset purchases until at least September under its tapered quantitative easing programme.

The statement, however, contained a subtle change from previous governing council meetings. It continued to state that net asset purchases, at €30bn a month, would run until the end of September 2018, or until the council sees "a sustained adjustment in the path of inflation consistent with its inflation aim".

However, the statement omitted any mention of the commitment to increase the size and duration of the programme if the economic outlook was to worsen.

Mildly hawkish

The initial reaction to the euro suggested markets interpreted this as mildly hawkish, as the single currency reversed early losses to rise against its main rivals.

Claus Vistesen at Pantheon Macroeconomics, however, believed the ECB move to be "slightly odd".

He said: "It means that the ECB potentially is willing to continue buying €30bn per month beyond September, but has jettisoned the willingness to adjust the program in response to a change in economic conditions.

"Apart from being a contradiction, it also locks in the ECB to a narrow range of policy choices."

Odd, or not, while the ECB needs to communicate effectively its intentions to gradually remove stimulus and begin steps towards policy normalisation, it does not want to do so at the risk of driving the euro rapidly higher.

The euro initially moved higher on the hawkish message implied in the policy statement: Pixabay

Fed’s dovish rate hikes

Let's not forget that during a period of more than a year when US policy normalisation is well advanced, the Federal Reserve's interest rate increases have done nothing to support the dollar.

While dropping a sentence that has been in the statement since 2016 is a significant change, Draghi gave his best downplaying this significance during the press conference
by Carsten Brzeski, eurozone economist at ING

Indeed, since the beginning of 2017 - and three quarter-point rate hikes from the Fed - the dollar has lost more than 12% on a trade weighted basis. During this time the euro has gained 17.5% against the US currency.

Economic growth in the eurozone, while robust, has never reached levels in this cycle to have caused any inflationary problems. And at this stage in the economic cycle, growth can become fragile very quickly.

Trade wars

With the strong euro already exerting pressure on Europe's exporters, the last thing ECB policymakers wanted to hear was President Trump planning to enact trade tariffs in the US.

"An escalation of trade wars would lead to greater political uncertainty and a weaker US dollar. As uncertainty increases, longer term confidence in the economic outlook reduces," says Phil McHugh, chief market analyst at Currencies Direct.

During the subsequent ECB press conference, Draghi was able to tone down any hawkishness in the statement in his responses to questions from the assembled group of journalists.

“While dropping a sentence that has been in the ECB’s statement since 2016 is a significant change, Draghi gave his best trying to downplay exactly this significance during the press conference,” said Carsten Brzeski, eurozone economist at ING.

On the Trump tariffs he said potential trade disputes "would introduce higher uncertainty in the future growth path".

He also reminded Trump that previous trade wars had typically led to a strengthening of the dollar.

Despite a hawkish statement, Draghi's dovish message at the ECB press conference won out in the markets: Flickr

Inflation subdued

But it was on the path of policy tightening that Draghi dialled back the most on.

While ECB inflation projections have consumer prices hovering around the 1.5% inflation rate by the end of 2018 and rising gradually over the medium term, Draghi told reporters that underlying inflation measures will remain subdued - so "victory cannot be declared yet".

Vistesen at Pantheon added: "Draghi stuck to the main dovish elements of the ECB’s communication strategy: underlying inflation remains subdued and ample monetary policy stimulus is still needed to bring inflation back to target."

Market reaction

On the currency markets the dovish message won out. Euro bulls capitulated and by mid afternoon in Europe on Thursday, the single currency was down 0.62% versus the dollar to $1.2334. Against the pound, the euro was 0.13% lower at £0.8916 and fell 0.65% to Y130.81 versus Japan's yen.

Equity markets, meanwhile, like low inflation and the promise of low interest rates and, thus, loved Draghi's comments.

Half an hour before the close of trade on Thursday, the EuroStoxx 50 was up 1.05% at 3,415. Germany's Xetra Dax added 0.79% to 12,342, while the CAC 40 in France was up 1.29% at 5,254.

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