Jefferies

Economics and Strategy

European Outlook – ECB and BoE Prepare to Adjust Policy; EU and UK Struggle to Adjust Relations

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

Slowly but surely the global central banks are taking steps to normalize policy, with the U.S. Fed preparing to reduce its balance sheet, the Bank of England (BoE) aiming to raise rates in the coming months, and the ECB looking to ‘adjust’ QE purchases next year.

In some ways, the ECB’s position is not all that different to 2015, before QE started: headline inflation remains subdued, the official core inflation forecasts are again being revised lower, and long term inflation expectations and wage growth remain adrift of where the ECB would like them to be. And the currency, a tailwind boosting growth in 2016 and 2017, could soon become a drag.

Nonetheless, the confidence surveys across the region are robust, unemployment is falling, and the ECB feels justified to start phasing out some of the extraordinary stimulus it had been providing. The meeting on 26 October will be key, as the ECB outlines its actions for the first half of 2018 at least. With the Governing Council weary of an unwarranted tightening in monetary conditions, the markets are preparing for a gradual reduction in monthly QE size; but anything more aggressive, such as an outright taper, would surprise expectations.

Peeking ahead to a post-QE world where the central banks are not indiscriminately purchasing large chunks of government debt, individual country fundamentals could start to matter much more. The pace and effectiveness of economic reforms in France will be more closely scrutinized. Similarly, as next year’s Italian elections approach, the outlook for 2018 is less certain without the safety net of indefinite central bank intervention. There will also be more uncertainty about the role that Germany may be prepared to play in any future European bailout after the election result that reduced Angela Merkel’s domestic standing and authority.

In the UK, the policy debate is heating up, both with respect to Brexit and the BoE. The Monetary Policy Committee (MPC) is preparing to reverse the emergency rate cut of 2016, with a move in November or in February in play. The collective judgement seems to be that Brexit reduces the UK’s trend growth rate, which means that the MPC may look to raise interest rates even on what are seen as relatively soft GDP prints.

As far as Brexit negotiations are concerned, Theresa May signaled her preference for a transitional arrangement in 2019 and 2020 with the UK contributing to the EU Budget in exchange for maintaining the existing trading arrangements. But that still doesn’t address the issue of the broader divorce bill, nor the future trade relationship after 2020 and, importantly, Ireland. Fifteen months after the Brexit vote, the UK outlook remains murky, with the negotiations seemingly producing limited progress. FULL REPORT