ECB forecasts put inflation near target, but markets remain wary
- ECB projections more upbeat with “a significant increase in headline inflation”
- A lower exchange rate will result in higher import prices in the euro area
- Markets are aware that the ECB's macroeconomic forecasting is not that good
By Max McKegg
The European Central Bank’s monetary policy review statement contained no surprises, suggesting a steady-as-she-goes approach with interest rates remaining “at present or lower levels for an extended period of time”.
While risks to the Eurozone growth outlook still being seen to be on the downside, “the balance or risks has improved”. However, the ECB remains wary that the low inflation environment over the last few years will lead to second-round effects on wage and pricing settlings, similar to the way the “deflationary mindset” has descended on Japan.
The quarterly ECB Staff Macroeconomic Projections, a guideline but not gospel for the Governing Council, are released at the same time as the monetary policy statement.
This time around the projections were a bit more upbeat than in the past, with “a significant increase in headline inflation” foreseen in 2017, extending further the following year.
The recent flash estimate for Eurozone inflation has it bogged down at -0.1% but, as shown in the chart below, the staff projections have the Harmonised Index of Consumer Prices (HICP) rising to 1.3% next year and 1.6% in 2018.
The shaded area represents a margin-of-error based in the Staff’s forecasting track record.
Source: European Central Bank
The margin of error looks symmetrical but the Staff prefer to accentuate the positive in the June projections. This shows up in the sensitivity analysis, which uses “alternative paths” for key inputs into the forecasting model, principally around the exchange rate and the oil price.
For the exchange rate the technical assumption underlying the baseline inflation forecast is that EURUSD will average 1.13 this year and 1.14 in 2017 and 2018.
But the alternative path has it trending down to 1.04, stemming from “a divergence in the monetary policy stance on either side of the Atlantic”, especially if there was to be “further monetary policy accommodation” in the euro area at the same time the US Federal Reserve was going in the opposite direction.
These potentialities, of course, are captured in market pricing and so (for the nerds) the 1.04 alternative path “is based on the 25th percentile of the distribution provided by the option implied risk-neutral densities for the USDEUR exchange rate”.
A lower exchange rate will, all else being equal, result in higher import prices in the euro area, and therefore under this scenario the Staff project headline inflation in 2016, 2017 and 2018 would be between 0.1 and 0.3 percentage points higher than in the baseline forecast.
The Staff also see positive risks around the oil price. The baseline assumption is that the oil price will trend higher to $52/barrel by 2018.
This is simply using the current futures curve. But using “a combination of alternative models” the Staff say there is a credible case that oil will actually rise more than that, perhaps by 10%. If so, euro area inflation would be about 0.2 percentage points higher in 2018.
Combining the alternative paths for the exchange rate and oil, we can add 0.4% to the 2018 baseline projection of 1.6% and arrive at the magical 2% that central banks always and everywhere are trying to engineer.
It all sounds credible enough but markets aren’t buying it. When it comes to inflation they want to see the whites of its eyes.
Hence, as this chart shows, the 5 year/5 year forward inflation swap is not rising much, being still under 1.5%. The market is saying that in five years from now, the outlook for inflation in the 2021-2026 period will be stuck at that level.
That suggests a deep-seated conviction that disinflation in the euro area is structural, rather than cyclical.
The ECB Staff Macroeconomic projections outline a credible case for inflation rising to the “below, but close to, 2%” target within a couple of years.
All else being equal that would require a 10% decline in EURUSD from today’s level and a similar adjustment upward to the oil futures curve.
Markets are dubious that such quick-fixes will outweigh structural disinflationary pressures. They are also aware the Staff’s forecasting record is not that good.
My Weekly Technical Analysis of EURUSD appears below. For today, I am focusing on a shorter term trading opportunity.
EURUSD weekly chart (click to expand)
-- Edited by Adam Courtenay
Max McKegg is managing director of Technical Research Limited. If you would like an email notice each time Max posts a trade, then click here to follow him.