The European Central Bank is likely to keep interest rates on hold when it meets Thursday, keeping rates at 1.5% for a third straight meeting. However the challenges to the euro zone economy have grown substantially in the previous two months and the expectation I have is that we see a more dovish ECB, which highlights the concerns to the outlook for growth. What complicates the picture is an inflation rate that not only remains persistently above the 2% ECB target, but has actually increased over the last 2 months.
Our first inclination of a slowdown in the euro zone economy came with second-quarter GDP data from Germany (0.1% q/q) and France (0% q/q) which showed the two largest countries in the euro zone stalling. The data since then has only reinforced the fact that the euro zone economy may dip into negative territory for the fourth quarter. Mainly we are looking at the manufacturing and services PMI's in this regard as their the most timely us indicators of overall activity in those key sectors.
Above is the composite PMI (both services and manufacturing) and with the manufacturing PMI falling to 47.1 and the preliminary October services PMI down to 47.2, it tells us that the euro-zone economy is well within contractionary territory. For this indicator the 50 level separates the level where growth is positive compared to negative. Such big drops and manufacturing and services implies that domestic demand is faltering and that there are not enough new orders for manufacturers and services industries.
As the above chart shows, the PMI's predict a move towards flat or negative growth for the quarter, which has to have the policy makers at the ECB very concerned.
The sovereign debt crisis rightfully has European households concerned about their future finances including the possibility of more declines in stocks and a further plunge in the euro if we have a disorderly default in Greece. Less confidence households makes more less consumer spending, which means businesses will cut back on orders to replace inventory - all a negative feedback loop type cycle.
The chances of a disorderly Greek default was more prominent in late August and early September, and European politicians had seemed to get on top of the situation in last week's EU summits. However this week, with the surprise call for a referendum by the Greek Prime Minister, those concerns have come back to the forefront and are again likely to damage confidence.
ECB's Outlook on Inflation to Determine Scope for Any Easing in ECB Policy
With the most recent data pointing to a slowdown in the macro economic picture for the Euro-zone the focus for the ECB will therefore be on the medium-term outlook for inflation. If the ECB decides that inflation will come back down in the medium-term from its current levels above its target of 2% then they may feel they are in a position to lower interest rates in the near term. However if they see inflationary pressures continuing to pose a problem then they are less likely to hint at monetary policy easing.
Recent inflation data shows that consumer prices rose to an annual rate of 3% in September, moving above the peak in CPI (2.8%) seen earlier in the year. On Monday, the preliminary reading for October's CPI also showed the annual pace of inflation at 3% (not reflected in the above graph).
The move back to 3% comes after a dip in prices in July and August which coincided with a fall in commodity prices. During the first half of the year the ECB was very concerned overall with the pass-through of higher commodity prices into underlying inflation.
Here's a look at commodity prices using the Thomson Reuters/Jefferies CRB Commodity Index for a similar period as the annual inflation chart I have above:
So far the concern that higher headline inflation will work its way into higher wage demands thereby sparking a stronger trend in underlying inflation have not yet taken place. The core annual inflation rate in Europe was at a 1.6% annual rate in September, though up from 1.2% in August. Still, commodity prices have declined of late, and it's likely worrisome for the ECB that inflation did not peak at the same time.
In the last ECB meeting then President Trichet said that the inflation outlook is broadly balanced. If the incoming President, Mr. Draghi, changes that wording to reflect that risks to the inflation outlook are on the downside that would be our clearest indication of a coming rate cut.
Key Questions for the ECB and its new President:
With that background being laid out, let's consider the main questions that we have for the ECB as we head into the meeting.
- Will the ECB, seeing the weaker macro picture hint at lower interest rates? Such a move would be euro negative.
- What's will the ECB say about its bond purchase program now that the EFSF has been ratified by all euro-zone governments and is closer to coming online? Mainly, will the ECB continue to carry on its bond purchases even after the re-worked bailout fund comes fully into force? If the ECB shows determination to pull out of this responsibility, that would be a negative for the euro because of its impact on the stability of financial markets. If it decides to continue its bond purchase program to complement what the EFSF is doing that should help boost the euros fortunes as it means more resources are at hand to deal with any changes in conditions in the periphery euro-zone bond markets.
- What does the ECB think of the 50% Greek write-down agreed to by banks and politicians during last week's Summit, as well as the ECB's take on the Greek referendum and its implications. The more the market believes that a disorderly Greek default is possible, the weaker the euro should be.
- Finally the market will be closely monitoring to get a sense of whether the new ECB president follows in the so-called German style - with a heavy emphasis on price stability and the inflation target mandates - or if Mr. Draghi will show a leaning to use the power of the ECB to expand the ECB's role in helping stabilize markets and boosting economic growth. In the long term picture for the euro, the former would be a positive for the currency, while a more adventurous ECB would be a euro negative. In the short term, a more active ECB would likely help risk sentiment and therefore may prove to be a positive for the EUR.
The focus then is on 2 main things, the ECB's outlook on growth and inflation, and if it believes conditions are suitable - inflation is contained and the economy deteriorating enough - to go ahead and lower interest rates.
The second focus will be on what the ECB will do in regards to its non-standard measures now that we have a beefed up EFSF that is almost ready to step into secondary bond markets, and the way forward in terms of how the ECB will help the process of bank recapitalization and bank support, stabilizing bond markets, and what type of role the ECB wants to play in stemming this crisis under its new President.