The staff of the European Central Bank has now released the new macro-economic projections for the Eurozone and whilst the introduction sounds optimistic about an ever-increasing GDP and a relatively stable GDP growth rate, reading between the lines suggests we could see an extended Quantitative Easing program.
The ECB is probably correct when it claims the economic recovery will remain ‘robust’, but it also mentions the ‘favorable financing conditions’ as one of the main drivers of this economic recovery. This is quite the ‘catch 22’ scenario. The economy is recovering due to the low interest rate policy of the ECB, but without this ‘easy money policy’, the recovery would be either much slower or non-existing at all. Whilst we have heard several voices from ECB committee members the central bank is getting close to the point it will start to increase the interest rates again, the working paper from the ECB staffers is pretty clear on the need for continuous (monetary) support to protect the current economic recovery.
Source: ECB paper
What’s even more intriguing is the fact the ECB’s assumptions are taking an even LOWER interest rate into account. The study was based on the market circumstances and market expectations as of half August, and back then, the market was taking an average 10 year government bond yield of 1.3% in 2018 and 1.6% in 2019 into consideration. However, this has now been revised downward with approximately 10-20 basis points. This could indicate the market has started to price in a longer period of easy and free money.
And that’s an important starting point. As the loans to businesses (and individuals) are priced based on the anticipated ‘risk-free’ interest rate of a government bond, the lower expectations for sovereign debt yields will trickle down to the ‘real’ economy (underpinning the growth expectations), but it’s unlikely this effect will still be noticeable should the ECB reduce its QE program. That’s probably why the market is now expecting the three month EURIBOR interest rates to continue to be low, and even lower than when the previous quarterly survey was completed.
Source: ECB Paper
As you can see on the next image, even keeping the Quantitative Easing program unchanged, the GDP growth rate will slow down whilst the anticipated inflation rate will decrease as well to less than half of the ECB’s desired 2% rate.
Source: ECB Paper
The ECB comments this is due to a lower oil-related inflation impact and it expects the underlying inflation rate to increase again from 2019 on, but we do not necessarily agree with that view. After all, the weaker than expected US Dollar might increase the impact of the low oil price and extend the period wherein this impact will be felt.
Source: Danske Bank
Whilst most eyes have been on the Federal Reserve lately, the upcoming decision of the European Central Bank in October might be even more important. Several executive committee members have claimed the Eurozone is strong enough to sustain the recovery on its own, but we think it might be too soon for the Eurozone to stand on its own legs.
A reduction of the size of the Quantitative Easing program is definitely a possibility but this isn’t Utopia. The continuous support of the Central Bank is still needed.