Dispatch€s from Frankfurt – ECB Preview: The Fog of (Trade) War
Lowering my ECB terminal target to 1.75%
US tariffs have strengthened the case for a further 25bp cut by the ECB on April 17. On account of the hit to the euro area, I have lowered my expectation for the ECB terminus to 1.75%. With recent price action suggesting the possibility of at least a partial loss of market confidence in the US administration and US assets, the exchange rate of the euro is emerging as a major headache for the ECB.
Photo by Anna Goncharova on Unsplash
"War is the realm of uncertainty; three quarters of the factors on which action is based are wrapped in a fog of greater or lesser uncertainty." — Carl Von Clausewitz
April 17 meeting: cut coming
US tariffs and the associated fallout probably have changed the odds of the outcome of next week’s meeting quite substantially. Before, another 25bp cut to 2.25% looked likely (in my view) but was by no means a given.
Now a cut looks like a reasonably safe bet.
Before April 2, the case for a cut was given by the fact that inflation data have continued to come in in line with the ECB baseline (and broader inflation determinants, like wages, also looking consistent with the target).
The tariff announcements and the market response have added to the case for cuts.
Isabel Schnabel – considered by the market a “hawkish” policy maker – had this to say in an interview with Bloomberg last year.
“In general, tariffs would pose some downside risks to economic growth in the euro area. On the inflation side, it’s more complicated. On the one hand, tariffs could be inflationary, in particular if there’s retaliation. Then we would have rising import prices, reinforced by a weaker exchange rate. On the other hand, you could have weaker foreign and domestic demand and a diversion of trade from China to the euro area, which could dampen price pressures.”
Now that the first shots of the trade war have been fired, we have
no retaliation to the general tariffs (although there has been targeted retaliation on the sector-specific ones) in what has been a wise strategy by the EU so far; and
no euro depreciation: as I’m writing this, the common currency is up 5% against the US dollar since the initial April 2 “liberation day”, having previously appreciated by almost 6% from this year’s trough, in part also due to Germany’s fiscal announcements.
I have been arguing since last year that the impact of US tariffs should be net disinflationary. It turns out that – at least so far – there is nothing to net against the disinflationary impacts stemming from
reduced US demand due to tariffs
reduced global demand for euro area exports due to slower growth worldwide as a result of tariffs, uncertainty, and the hit to confidence
diversion of Chinese exports from the US to the euro area (faster renminbi depreciation comes on top).
In addition, the oil price is down.
How much more?
In my framework from last year, 10% US tariffs were worth 2 cuts.
I had incorporated one cut into my baseline (on the uncertainty, and on the assumption that there would be a deal lowering tariffs to 5% against EU purchases of military hardware and LNG – this hasn’t materialized so far), so that I ended up with 2.00% rates by June.
Assuming no further changes in the tariff picture and taking into account: a) tariffs on China being much larger than expected, b) worse damage to (global) confidence from the US administration’s tariff mess, I’m now adding the 2nd cut, which should arrive by September.
This leaves me at 1.75% terminal for this year and the cycle as a whole, with broadly balanced risks: much will depend on tariffs, on the one hand, and the timing of the arrival of the German stimulus in the economy, on the other.
In the near term, the major question is the size of the diversion effect from China, which is difficult to quantify.
This ECB analysis suggests a -0.4pp impact of Chinese factors for euro area headline inflation (via goods inflation), but the modelling framework doesn’t obviously apply to the question at hand, and the result is specific to a certain point in time in the past.
The euro headache
The bigger picture should probably be conducive to a somewhat more dovish ECB - even before considering the possibility of a major financial crisis.
My view remains that while the euro doesn’t have what it takes to replace the dollar as the global reserve currency on merit, it does stand to benefit from the deterioration in US institutional quality and its policy framework by default – see my report card on the euro’s reserve currency status.
At least on the margin, the emergence of Europe as more of a safe haven provides the ECB with a bit more space for easier policy in the near term.
More broadly, I believe we have embarked on a multi-year depreciation trend of the dollar against the euro (and other currencies) as the global economy rebalances.
However, the recent price action in financial markets – which carries more than a whiff of a loss of confidence in the US administration and even US assets – poses the question: can the euro area economy cope with such a rapid appreciation of the euro?
In the near term, if anything, the economy could use a weaker euro to cushion some of the loss of US exports.
So does everyone else, of course, which is why there’s a global monetary easing on the cards.
And in contrast to the other havens Switzerland and Japan, which do use FX intervention to at least slow currency moves, this isn’t a tool the ECB can activate easily – at least not yet.
But I’d wager that – the bigger picture being what it is – the strength of the euro and the speed of appreciation is having the ECB worried: expect journalist questions in the press conference – probably receiving a non-committal answer.
April communication
In the March meeting, the governing council had modified the language on its policy stance; it characterized the level of its policy rates as “meaningfully less restrictive”.
This seems consistent with the 1.75-2.25% range for the neutral rate identified in recent ECB staff work which President Lagarde had endorsed even prior to its publication.
By so doing, she’s established 2% as an implicit focal point for the internal discussion, communication with the outside world, and the market.
Thus, it would be consistent with this communications precedent if – provided there is a cut – the council tweaks the language further to reflect that, in its reckoning, the main policy rate has arrived at (the upper end of) neutral.
Given the overall meeting-by-meeting, data-dependent approach, this should not be a revolutionary change to communication, nor should it be taken as such by the market: considering the monumental changes in the global macro environment currently and its impact on the euro area and ECB monetary policy, where exactly rates are relative to some – in any case highly uncertain – estimate of neutral at this point becomes second order.
Christine Lagarde may well emphasize this in the presser.