Carsten Brzeski's blog

Eurozone: Draghi’s dilemma

Minutes of the ECB June meeting show the current ECB dilemma: how to take the first steps towards the exit without distorting markets

The minutes of the ECB’s June meeting, just released, show that the ECB was considering to even go beyond the June changes in its introductory statement. According to the minutes, the ECB had discussed to not only drop the easing bias on interest rates but also on the QE programme, ie dropping the phrase that QE could be stepped up if need be. However, the general tone of the minutes was still a dovish one. At the same time, the minutes also showed that the ECB had clear concerns that changes to the official communication could be misperceived by financial markets.

Today’s minutes come at a time at which speculation about a possible fast and imminent end of the ECB’s ultra-loose monetary policies have started again. The latest episode was the financial market reaction after ECB president Draghi’s speech in Sintra early last week. In our view, the Sintra speech was not overly hawkish. In fact, the Sintra speech looked like a first attempt to shift the ECB’s official communication and line of argumentation; away from inflation towards a new concept of a monetary policy speed limit. A new narrative to prepare tapering. With the knowledge of today’s minutes, however, this attempt to change the narrative one looks more like a Draghi initiative rather than a Governing Council decision.

Given the cyclical upswing, the disappearance of deflationary risks, opposition against QE from some ECB members and the scarcity problem of the bond supply, the ECB wants to move towards tapering. However, the absence of any inflationary pressure makes the narrative to move towards tapering a bit complicated. Remember that the ECB started QE as a means to bring inflation back to the “close to but below” 2% level.

In our view, Draghi’s key phrase in Sintra was ‘As the economy continues to recover, a constant policy stance will become more accommodative, and the central bank can accompany the recovery by adjusting the parameters of its policy instruments – not in order to tighten the policy stance, but to keep it broadly unchanged’. The ideal argument and new narrative for the ECB to prepare tapering even if lower oil prices and a stronger exchange rate could lead to further downward revisions of the ECB’s inflation projections in September.

More generally speaking, the ECB will continue facing very little homemade inflationary pressures. There are reasons to believe that wage growth in the Eurozone is bound to stay lackluster: slack in the labour market, sectoral and technological changes all argue against a fast pick-up in Eurozone wage growth. In addition, digitalisation, as long as it continues to increase in importance, both in B2B and B2C, is likely to insert downward pressure on consumer prices due to higher price transparency and more competition, now also in services.

All of the above means that the ECB’s tiptoeing towards tapering will continue. It should remain a very gradual and cautious process, given the ECB’s fear of taper tantrum and earlier negative experiences with premature rate hikes (in 2008 and 2011). Even though the ECB is clearly aware of the impact of its communication on financial markets and would preferably like to move towards the exit as quiet as possible, last week’s events have shown that this will not always be possible. Once in a while the ECB will have to be a daredevil to prepare financial markets.