Jackson Hole speech paves way for ECB asset purchase

On Bloomberg TV today Jon Ferro and I discussed Mr. Draghi and looked ahead to the ECM meeting and our view is that after Mr. Draghi’s speech at Jackson Hole, we can expect the ECB to announce a broad-based ECB asset purchase programme (QE), with Mr. Draghi’s comments arguably pre-committing the Governing Council to act later this year – and to date, whenever Mr. Draghi has pre-committed the council, the ECB has delivered.
Back in April, Mr. Draghi stated that he saw three challenges and three associated monetary policy solutions. First, if there were an unwarranted tightening of the monetary policy, with higher money market rates, yields and/or a stronger euro, then conventional measures such as rate cuts could be warranted. Secondly, if there was further impairment in the transmission of the monetary policy stance, in particular via bank lending, then TLTROs or an ABS purchase programme could be required. Thirdly, if there was a worsening of the medium-term outlook for inflation, then a more broad-based asset purchase programme might be needed.
At Jackson Hole, Mr. Draghi identified that the medium-term outlook for inflation had worsened. It follows that a broad-based asset purchase programme can be warranted and we can expect the ECB to start preparing the ground for QE at the September meeting with the Governing Council acknowledging the decline in inflation expectations, illustrated in the chart below. The ECB has consistently highlighted temporary factors, such as food and energy price movements as drivers of low headline HICP inflation, but low inflation runs the risk of becoming permanent once inflation expectations decline.
The medium-term outlook for inflation has always been at the base of the ECB’s sole objective, price stability and consistent with this focus, the ECB lengthened its forecast horizon for inflation, the HICP, by a year, to 2016 in March. The 2016 inflation projection was revised down from 1.5% to 1.4% in June and it looks like there may be revision down to around 1.3% at the September meeting. Importantly, the Q4 2016 projection has been revised from 1.7% as at March to 1.5% as at June, and is also likely to be lowered further, becoming increasingly more inconsistent with the ECB’s ‘below but close to 2%’ price stability objective.
In essence, Mr. Draghi’s Jackson Hole message was that there’s no more time to be complacent about deflation – although realistically delivery of the details and implementation of QE may take some months, perhaps coinciding with completion of the first TLTRO, AQR and stress tests.

On the issue of how important what people think can be, the need to anchor inflation expectations over the medium- to longer-term has been highlighted at each ECB press conference, and although headline inflation was declining, the ECB took comfort from the fact that expectations continued to be firmly anchored. But Mr. Draghi has now stated that the ECB will acknowledge ‘unanchoring’ at its September meeting and it’s clearly worrying him because in his original Jackson Hole text he had just a short paragraph stating that inflation had been on a downward trend and that the Governing Council would safeguard the anchoring of expectations, and he then amended his one short paragraph to four, noting that inflation expectations exhibited significant declines at all horizons. He pointed to the decline in the 5y/5y swap rate, one of the ECB’s gauges of medium-term inflation expectations, and highlighted the sharp fall in shorter-dated maturities.
We can expect that acknowledgement that expectations are declining will lead to further lowering of the September HICP ECB staff projections, and HICP inflation has sharply undershot the ECB’s projected path, and Mr. Draghi added in Jackson Hole: ‘if this period of low inflation were to last for a prolonged period of time the risk to price stability would increase’.
Meanwhile weak growth doesn’t help – weak real growth and weak inflation trends imply weak nominal growth, and weak nominal growth means real problems for the structural reform agendas and government finance challenges.  In June, the ECB revised down their forecast for GDP growth for this year, but revised 2015 up – but with poor PMI surveys and weak Q2 GDP numbers, the ECB looks set to revise its GDP growth projections down from the 1% and 1.7% that it has for 2014 and 2015, to perhaps 0.8% and 1.5%. This is also obviously worrying Mr. Draghi in that his Jackson Hole speech also focused on the importance of lifting aggregate demand, and provided a blueprint on how to stimulate economic activity and a to-do list for politicians. Yet experience shows that Euroland politicians don’t move quickly so barring a significant external shock, perhaps an escalation of the Russia/Ukraine crisis, major fiscal stimulus and significant reforms remain unlikely – so that raises the pressure on the ECB and monetary policy to deliver the required stimulus. In his speech, Mr. Draghi noted that “it would be helpful for the overall stance of policy if fiscal policy could play a greater role alongside monetary policy” and absent more fiscal stimulus, the ECB’s “monetary policy can and should play a central role”.
In practical terms, this suggests that QE is now more likely than not before year-end, unless economic growth and inflation data suddenly show emphatic signs of improvement – and this looks unlikely for the period ahead.
If QE is clearly signaled at the ECB’s September meeting, as the ECB have stated, QE only makes sense in an environment where banks are adequately capitalized – hence the reason why QE may be deferred until AQR and stress tests are behind us. As to what to buy, ECB members have repeatedly stated that QE would encompass a broad range of assets. Plans for an ABS buying programme have been worked on for some time and the appointment of a financial markets adviser is likely to accelerate the process but declining inflation expectations require a broader-based asset purchase programme.
Turning to implementation, the ECB’s Benoît Cœuré has already said that QE would have to have an impact on a range of assets that is broad enough to inject sufficient liquidity into the economy, that the focus would need to on lowering real interest rates for firms and households and that this implies “operations aimed primarily at impacting the level of the term premium across maturities and market segments”. He added that the range of purchases could be heterogeneous across countries, maturities and asset classes, and in practical terms the ECB could delegate QE purchases to national central banks.
In terms of market impacts, peripheral spreads have been the biggest beneficiaries of ECB accommodation up to now and would likely be compounded by a QE announcement but whilst an active ECB, either through credit or quantitative easing, is positive for the periphery, the longer term structural challenges argue that this is a high risk strategy. All that we might want to conclude for now is that the impact of QE on the level of yields and curve shape is very dependent on the perceived impact of QE on inflation expectations, and the longer-term market implications of QE are harder to discern due to the uncertainty as to the extent to which the ECB can affect real economic variables. Interestingly, after the SMP programme, which was opaque and limited, long-end rates rallied, curves flattened and peripheral spreads widened, whereas Mr. Draghi’s commitment to do “whatever it takes” saw peripheral spreads rally, long-end curves steepen, and inflation forwards rose.
The classic response to QE in the US was for the market to “sell the fact” and yields fell consistently in anticipation of QE announcements and on the announcement yields moved higher. This could happen with German yields given current valuations, but as the ECB has been slow to act and the impact of QE on increasing inflation expectations remains unknown, it isn’t clear whether an ECB QE programme would mark the turning point for yields. Ironically such a programme could be the turning point in other markets.
If Mr. Draghi and the ECB disappoint market expectations next week, we should expect the largest reaction in the periphery.

James Bevan is chief investment officer of CCLA, specialist fund manager for charities and the public sector. CCLA launched The Public Sector Deposit Fund in 2011 to meet the needs of local authorities and other public sector organisations. You can follow James on twitter @jamesbevan_ccla