ECB: Growth Concerns
The growth outlook has turned weak enough for the European Central Bank (ECB) to deviate from the quarterly cutting trajectory and make its first move outside a staff projection meeting. As the ECB had been guiding towards December at its previous monetary policy meeting, and the amount of data received since the September rate cut has been sparse, risk management considerations seem to have played an important role.
From a risk management perspective, the ECB likely believes that upside shocks to inflation can be addressed by a slower pace of rate reductions going forward, while the rate cut is offering additional protection against downside risks. While the October cut might suggest a desire to normalize policy more quickly, the ECB stressed that decisions will remain meeting-by-meeting, and the data flow over the coming months will decide the speed at which the ECB continues to make policy less restrictive.
Given still too high domestic inflation, largely reflecting price pressures in the services sector, monetary policy will remain tight for now, with a discussion around the appropriate neutral policy rate expected to come into focus next year. While we do not have a strong view on the precise trajectory, another rate cut in December seems likely, and a terminal rate pricing of around 1.85% for the second half of next year remains consistent with our (and most external) estimates for a neutral policy rate for the Euro area.
As a result, we broadly agree with market pricing and see limited upside for European duration outside a recessionary environment, so our stance remains broadly neutral. As for the European interest rate curve, we continue to expect the back end of the interest rate curve to underperform shorter maturities due to gradual rate cuts and rebuilding term premia.
Waiting for the recovery
Data have been on the weaker side regarding growth, the labour market and price developments. While the Euro area economy grew by 0.2% in the second quarter, growth stemmed mainly from exports and government consumption, while private domestic demand remained weak. The long-anticipated household-led recovery has so far not materialised, and survey indicators suggest continued headwinds.
The fall in the Eurozone Purchasing Managers' Index (PMI) in September, from 51.0 to 48.9 points, was due in part to payback in France following an Olympics-related bounce in August. However, even adjusting for that, the index looks soft, held down in part by a continued underperformance of German manufacturing, and points to economic stagnation in the eurozone. While the labour market remains resilient, with the unemployment rate still at a record low of 6.4%, employment growth slowed to 0.2% in the second quarter, and recent indicators point to a further deceleration ahead.
Inflation fell to 1.7% in September, from 2.2% in August, dipping below the ECB's target of 2% for the first time in three years. As in the previous month, the fall was mainly due to a further drop in energy prices. Core inflation fell only slightly to 2.7%, from 2.8% in August. Due to the persistently high price increases for services, standing at 3.9% in September, the core inflation rate is likely to remain well above the ECB's target in the coming quarters.
At the same time, growth in labour costs has been moderating and profits have been buffering the impact on inflation. As the ECB has been pointing out today, the inflation outlook will be affected by recent downside surprises in indicators of economic activity. While headline inflation should temporarily increase in the fourth quarter due to base effects, the ECB seems increasingly confident that inflation will durably converge to target in the second half of next year.
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