ECB: crisis avoided (again), but risks remain

Tomorrow we get to hear the latest from President Draghi on the outlook for the euro area, and more on the modalities of the QE programme. As part of their regular roadshows outside of Frankfurt, tomorrow comes from Cyprus. Which is kind of interesting, as with capital controls still in place there, is a Cypriot euro really the same as a non-Cypriot one? I hope Draghi doesn’t find himself short on cash, as you can still only withdraw €300 a day.

I certainly felt back in March of 2013 that events in Cyprus were going to be a big deal for the EA. But within a few weeks everyone had forgotten about it and let them get on with their lives. Since then, output has fallen by another 5% (bringing the total decline to over 10% from the peak in 2011), unemployment has been around 16% and deflation has persisted. So not obvious that you would call that a great success. No doubt Draghi will be expecting some tough questions from local journalists.

With the big announcement of sovereign QE in January, tomorrow is likely to be a relatively quiet affair. We will no doubt get a bit more detail on the modalities of the purchase programme. But more importantly we will get updated staff forecasts, including a first look at 2017. Draghi was clear in the December 2014 press conference that the forecasts did not incorporate all of the decline in oil prices, and therefore the near-term inflation forecast will no doubt be revised materially lower. But it will be the 2016 (currently 1.3%) and 2017 inflation forecasts that are of much more interest. Hard to see 2016 moving up, but with the policy action announced in January, and some more encouraging signs on the growth front (eg PMIs continue to steadily improve, retail sales have been remarkably good and even Q4 GDP was decent), it may be that the staff could now see inflation getting closer to target in 2017 than previously thought.

One tricky aspect is how they incorporate the boost from QE. Purchases haven’t even started yet, and there is only an intention to purchase through to September 2016. So quantifying the impact of those purchases will be difficult. What is clear though, is that the euro is around 7% weaker (on trade-weighted basis) since the last forecast, rates are materially lower across the curve and 5y5y inflation swaps are back up around their mid-November level.

So overall I expect Draghi to sound fairly positive tomorrow. To be sure, the downside risks on the inflation front remain very concerning, and will continue to be the main driver of policy. And should they look to be materialising, I expect that the ECB will react by increasing the pace of purchases (which as announced in January are only about half as fast as the Fed or BoE at their peak). But with activity (very) steadily improving, oil prices well off their lows (helping to reverse some of the downward pressure on near-term headline inflation) and global sentiment somewhat improved in the past month or so, there is reason for the ECB to be a little more optimistic about the outlook.

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