Jefferies

Economics and Strategy

European Outlook – ECB Tapering and the UK Heading Back to the 1970s

— David Owen, Chief European Financial Economist
— Marchel Alexandrovich, European Financial Economist

After the conclusion of the elections in France, and with the likelihood of the early Italian vote receding, the European political calendar is quiet until the German Bundestag elections on September 24. This year had the potential to throw up some significant political challenges in Europe, but, Brexit negotiations notwithstanding, the focus can now turn back to monetary policy.

The challenge for the ECB is how to start normalizing policy in the face of stubbornly weak core inflation. From the ECB’s perspective, the fact that deflation risk is lower than it was when QE started in 2015 is encouraging. But the slack in the labor market remains significant, wage growth continues to disappoint and the euro area is still some way off from ‘normal’ inflation dynamics.

In response, the ECB is bound to be patient in removing stimulus, with Mario Draghi signaling that QE will carry on well into 2018 and, importantly, reaffirming the commitment to policy sequencing whereby the deposit rate will not rise until after QE comes to an end. Yet, on a more hawkish note, there is also perhaps increasing acceptance at the Governing Council that it may take significantly longer than previously thought to get inflation sustainably back to target. This means that, perhaps like the U.S. Fed did back in 2014, the ECB will look through the weak inflation data and start to normalize policy regardless.

As such, the markets are generally prepared for the ECB to take the foot off the pedal, but it is still anyone’s guess how quickly purchases wind down next year. Further confusion may arise if the ECB is forced to amend some of the Public Sector Purchase Programme rules as QE is extended. In terms of some of the longer-term challenges, as the global central banks prepare to reduce their dominant presence, there will be a much greater focus on the euro area’s large current account surplus and how private sector capital flows are recycled.

With regard to the UK, the snap General Election was called to shore-up the government’s position but produced the opposite outcome. One could envision very different scenarios in terms of what a hung Parliament means for Brexit negotiations, but ultimately it will be the rest of the EU that primarily determines the direction of travel. The rights of EU citizens, and perhaps the broad terms of the divorce bill, should be settled quickly, but nothing else will be. Trade negotiations, which may end up raising and not lowering barriers to trade, are unpredictable from the start.

The Bank of England also surprised this month, with the Monetary Policy Committee juggling the effects of a weaker currency on inflation and the all too familiar problem of soft wage growth. A rate rise this year remains unlikely, but the debate has stepped up a gear. Mark Carney’s Mansion House speech was important, less so in its implications for rates, but more for what it said about services as the UK heads towards Brexit. FULL REPORT