Having sent a mixed message for some time, the ECB is increasingly signalling it is ready to take action. Since the February meeting, it has worked on the 2016 inflation forecast - a crucial input to its decision at the March meeting. Judging from recent comments, it will be low enough for the ECB to ease policy. For example, the ECB's chief economist Peter Praet stated that 'weakness in price development is extending to the medium term'. In that case, it is clear from the ECB's mandate that it needs to take action. We look for it to publish an inflation forecast of 1.6% for 2016 (see Euro inflation research no 3: ECB's medium term outlook for inflation , from 26 February 2014). Although February Flash inflation surprised by being unchanged at 0.8% y/y rather than falling, it does not change the picture of very low inflation. Other factors pressuring the ECB include weak credit growth and a sharp decline in inflation expectations in financial markets.
We look for the ECB to stop the sterilisation of the SMP programme , which would increase short-term liquidity by around EUR180bn in March. In the spring, we expect the ECB to ease further by cutting the deposit rate to -10bp (see Euro inflation research no 5: ECB will ease again& and again , 28 February 2014). The ECB's action would not mean it can get inflation up but it needs to act to avoid inflation expectations going lower with the risk of inflation going even lower and possibly into negative terrain. In that sense, it is more connected to damage control than the ability to really push inflation higher. If the ECB refrains from taking action, it risks EUR/USD going higher, which would add further downward pressure on inflation. Inflation expectations are also likely to decline, which in itself would lower wage increases and increase the likelihood of deflation.
So, what would easing mean for financial markets? For stocks, it would be a supportive factor, as it would raise liquidity and strengthen the outlook for rates to stay low for a long time and thus keep the risk free rate very low. The ECB's action would also be positive for growth by contributing to more declines in peripheral bond yields, pushing up sentiment and growth in southern Europe. The easing would keep downward pressure on core bond yields intact as well. For EUR/USD, it would help to cap the rise in the cross, which is important when the other side of the cross - the US - is slowing down, putting upward pressure on EUR/USD. However, the effect of ECB easing on EUR/USD would be a two-edged sword. This is because easing would also spur more capital flows into southern Europe as it would encourage investors to buy more bonds and other assets there. We believe EUR/USD will eventually go lower when the US economy recovers again and that US short-term money market rates will rise. However, in the short term, EUR/USD is captured in a range in a tug-of-war between the above factors.
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