Article / 04 September 2017 at 16:02 GMT

ECB challenged by sluggish inflation, appreciating euro — #SaxoStrats

Head of Macro Analysis / Saxo Bank
France
  • ECB governing council meets on Thursday; announcement due at 1145 GMT
  • ECB meets in a precarious situation marked by heightened geopolitical uncertainty
  • Geopolitical Risk Index is at highest level since 2003 invasion of Iraq
  • Eurozone economy is performing much better than before
  • Biggest challenge for ECB is sluggish inflation
  • ECB will eventually need to lower inflation forecasts for the coming years
  • Euro is up 12% vs USD and 6% on average vs 38 leading trade partners' currencies
  • Euro's strength could soon hurt economic growth if ECB fails to halt appreciation

ECB headquarters and the Frankfurt skyline
 Aerial view of Frankfurt and the European Central Bank, where 
policymakers meet on Thursday. Photo: Shutterstock


By Christopher Dembik

The European Central Bank's governing council meets on Thursday this week to decide on monetary policy in a precarious situation marked by heightened geopolitical tensions, sluggish Eurozone inflation and an appreciating euro that could soon spell trouble for European economic growth.

Based on the latest market developments, it is becoming quite clear that the ECB will need to deal not only with the complexity of tapering quantitative easing, but also the uncertainty linked to the geopolitical tensions on the Korean peninsula. 

The Geopolitical Risk Index (based on Caldara and Iacoviello’s work) is at its highest level since the 2003 invasion of Iraq. It currently stands at 284, against 455 at that time, and far above the historical mean of only 83.7 over the 1900-2017 period. In this context, very careful communication from the ECB is required to avoid any overreaction of the financial markets on Thursday afternoon.

Geopolitical risk index
 

In terms of economic performance, the euro area is doing much better than before, which confirms that the current level of accommodative monetary policy might not be necessary anymore. Growth is expected to exceed 2% this year. The Citi Economic Surprise Index (CESI) for the euro area remains well-oriented and keeps over performing that of the US and of the G10.

The Eurocoin advanced growth indicator has continued to rise since 2014 (+0.67% in August).

Eurocoin advanced growth indicator
 
Furthermore, our in-house Credit Impulse Index for the euro area (which measures change in new credit issued by the private sector as a % of GDP) is following a positive trend, especially in core countries like France and Germany, in spite of a recent slowdown.

Credit impulse France
 
Credit impulse Germany
 
However, economic disparities remain well-entrenched between core countries and the euro area periphery, as shown by the decline of our Credit Impulse Index for Italy since its last peak in April 2016.

Credit impulse Italy
The biggest challenge for the ECB is sluggish inflation. Only five Eurozone countries (Austria, Belgium, Germany, Luxembourg and Spain) have inflation close to the ECB's medium-term target for inflation "below, but close to, 2%”. In addition, despite stabilisation this summer at 1.3%, the euro area core CPI is still lagging behind.

Harmonised CPI


























Our model of Domestically Generated Inflation (based on GDP deflation, service prices and wage growth) is slowing down, which indicates that a spurt of domestic inflation is quite unlikely in the coming months. Only external factors (meaning energy prices) could help the ECB reach its target in the near and medium term. Based on the weakening of our model and the recent appreciation of the euro (the ECB’s June staff projections were at 1.09 for the EURUSD), it is now certain that the ECB will be constrained to revise its inflation forecasts downwards for the coming years.

DGI euro area
 
If the ECB does not manage to limit or stop the appreciation of the euro, the currency's strength might quickly have a negative impact on growth and earnings. Since December 2016, the euro is already up 12% against the US dollar and 6% on average versus the currencies of the Eurozone's 38 leading trade partners. We usually consider that every 10% surge in the euro destroys as much as 7% to 8% of Eurozone corporate earnings. So, it might not take long to see the negative influence of an excessively strong currency on the European economy.

Conclusion

The ECB’s mission this Thursday is twofold:

1) Due to the geopolitical context and lagging core inflation, the ECB will need to weigh its words very carefully to avoid investors’ overreaction. It will need to send a message that its monetary policy will remain accommodative for a prolonged period of time, no matter what decision concerning QE is unveiled by the end of the year.

2) The short-term objective should be to halt the appreciation of the euro, which reflects an improving economic situation, but this trend could seriously complicate the ECB’s task in the coming months.

ECB president Mario Draghi
 



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The appreciating euro could soon become a problem for European growth and 
earnings, and therefore also for the ECB's Mr Draghi & Company. Photo: ECB webcast


Edited by John Acher

Christopher Dembik is head of macro analysis at Saxo Bank

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