Market update: Mario Draghi, the Last Dove?

A little over two months into 2018 and we are having to fundamentally re-appraise what we thought we knew about how central banks make decisions.  Simply put, this ‘reaction function’ are the policies they enact for a given set of economic conditions. More often than not, these are signalled to markets through so-called ‘forward guidance’, particularly when those same central banks think that markets have got it wrong. Indeed forward guidance is itself a policy tool.

Since the start of 2018 expectations of where policy rates will be two years hence have risen by 0.44% in the US and 0.35% in the UK. Previously dovish members on these central banks boards are now sounding very hawkish indeed. Even in Japan, where rate hikes remain a very distant prospect, the Governor of the Bank of Japan has now openly contemplated the end of Quantitative Easing (QE) – although he quickly back-peddled.

What has a partially wrong-footed markets is that this move has come against only a very modest pick-up in inflation expectations. This is true whether these are near-term economist forecasts of inflation, or longer-term market-based measures. It is largely central banks that have changed their tune, though as ever they seem pathologically incapable of admitting as such.

Against this sea-change, Mario Draghi, President of the European Central Bank (ECB) cuts an increasingly lonely figure. At the rate decision meeting later today he is likely to push back against a firm timetable for further tapering of the ECB’s own QE programme, let alone its end or a hike in interest rates. The Bank is clearly unnerved by the strength of the Euro, market volatility and the potential for trade protectionism  to disrupt the ongoing Euro zone recovery.

But low for how long? Despite concerns,the new economic forecasts for the Euro zone are likely to be largely unchanged today. Although momentum seems to have peaked, the Euro zone recovery continues apace. Profits at most Euro zone companies are growing strongly. Unless something radically changes, it is only a matter of time until the ECB signals slightly tighter policy, though one would hope rather less clumsily than their counterparts elsewhere. (Yes Mark Carney, I’m thinking of you).

ECB is tied in on QE. Essentially, the ECB is on autopilot as regards their QE programme. Having tapered (or as the ECB prefers to say ‘recalibrated’), in January they are likely to do the same in October before ending the programme entirely at the end of the year. The rhetoric of potentially firing up the programme again if the need arises rings rather hollow when they are running out of bonds to buy in countries such as Germany.

But much less so than rates. A year ago, the clamour from bankers for Mario Draghi to abandon negative deposit rates was deafening. Today it is barely a murmur. Inflation performance remains weak and on current forecasts won’t even hit target in 2020. Expectations for a hike this year have actually fallen and at present the market is assuming that the first rate hike is more than a year away. What happens thereafter is less certain. Mario Draghi leaves the ECB in October 2019.