Article / 09 September 2016 at 1:55 GMT

ECB staff projections justify board decision to sit tight

Managing Director / Technical Research Limited
New Zealand
  • The ECB has done the right thing by sitting on its hands on this occasion
  • Inflation could well be within sight of the ECB’s target this time next year
  • But all bets are off if we have another crude oil selloff

By Max McKegg

Volatility in the financial markets is as low as I have seen it in the 15 years I have been contributing analysis to Saxobank. The extended sideways pattern in EURUSD is a case in point. This is frustrating traders who want “someone or something” to generate action.

Yesterday they looked to the European Central Bank, but President Mario Draghi and his colleagues disappointed them by sticking with a steady-as-she-goes course for monetary policy. Frustrating as this was for traders, a study of the commentary around the decision and the economic forecasts that accompanied it suggests the ECB has done the right thing by sitting on its hands on this occasion.

 Energy is key ... ECB inflation forecasts assume Brent crude prices will rise in line with the current futures curve, but all bets would be off in the event of another oil selloff. Photo: iStock

The baseline ECB staff macroeconomic projections show headline inflation averaging only 0.2% this year before rising “substantially” to 1.2% in 2017 and trending up further to 1.6% in 2018. As usual there is a significant margin-of-error band around the projections, based on the staff’s track record in forecasting. Thus, by the end of the projection period, inflation could be as high as 2.4% or as low as 0.9%. The following chart shows the margin of error around the baseline forecast.

Euro area Harmonised Index of Consumer Prices (HICP)

Source: ECB

The substantial jump in inflation projected for 2017 is the main reason the ECB thinks it is justified is riding out the low numbers we are seeing this year. The board’s post-meeting statement put it this way: “looking ahead, on the basis of current oil futures prices, inflation rates are likely to remain low over the next few months before starting to pick up towards the end of 2016, in large part owing to base effects in the annual change of energy prices”.

Base effects refers to the fact that as months pass, the impact of previous oil price declines drops out of the year-on-year inflation calculation. This is illustrated in the following chart, which shows the inflation rate rising smartly to 1.2% early in 2017. The calculation assumes Brent crude will trade in line with current futures curve, rising to around $47/barrel.

Of course, all bets are off if oil were to have another sell-off.


Source: Allianz

Other technical assumptions underlying the staff forecasts are that EURIBOR will remain negative during the forecast period and that EURUSD will average 1.1100. The exchange rate assumption is not a forecast as such; it is simply the average level EURUSD was trading at in the two week period leading up to the day the staff finalised their forecasts (August 11). So the gains seen in the overall value of the euro since the asset purchase program was introduced in March 2015 are expected to be maintained, as shown in the chart of the Trade Weighted Index below.

The staff forecasts acknowledge that the euro rally in recent months comes at a cost to the inflation outlook, saying “the gradual fading of upward pressures from the past depreciation of the euro is expected to weigh on the pick-up for HICP inflation excluding energy and food over the projection horizon”.

Thus core inflation is foreseen to average 1.3% next year and 1.5% in 2018, the latter number being lower that the forecast headline rate, which will be of some concern to the ECB. There’s no doubt they would prefer the euro to give up some of its gains from an inflation-targeting perspective.


Source: Allianz. Create your own charts with SaxoTrader; click here to learn more.

The chances are that EURUSD is not going to hold steady around 1.11 for the next two years, nor will Brent crude stick to the path suggested by the futures curve.

Helpfully, the staff provide an “alternative scenario” for these two key variables and shows where it leads.

On the oil price, the staff assume the most likely scenario is that Brent crude ends up about 11% higher by the end of 2018 that the current futures price of $51.6/b. They say this would “marginally dampen real GDP real growth, while entailing a somewhat faster increase in HICP inflation (up 0.1 percentage point in 2017 and 0.3 percentage point in 2018)”. Nothing spectacular perhaps, but every bit helps.

As for the exchange rate, the alternative path is based on the “25th percentile of the distribution provided by the option-implied risk neutral densities for EURUSD”. This implies a gradual decline in the cross rate to 1.04 in 2018 and would mean the overall value of the euro (as measured by the effective exchange rate or trade weighed index) ends ups being 3.3% lower than in the baseline forecast. This would increase the rate of inflation by 0.1-0.2 percentage points.

The baseline scenario projected inflation of 1.6% in 2018. If the stars line up so that both these alternative paths came to pass, then that number would rise to 2.00%. Neither is particularly ambitious and it’s not hard to come up with an economic outlook in which both turn out to be correct.  In turn that would mean the chances of inflation being well within sight of the ECB’s target come this time next year are quite good.

The ECB statement made it clear the monetary pump-priming peddle would remain flat to the floor “until the Governing Council sees a sustained adjustment in the path of inflation”. They won’t see it in 2016, but come the turn of the new year and the picture will be looking much brighter.

Edited by Robert Ryan

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Max McKegg is managing director of Technical Research Limited. If you would like an email notice each time Max posts an article or trade, then click here to follow him.


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