Draghi generates positive surprise says ING

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Willem Verhagen, senior economist at ING Investment Management (ING IM)  analyses the ECB announcements.

Draghi’s speech at Jackson Hole raised expectations of further ECB easing and so, it is very important that the ECB deliver on these expectations to prevent another shock to the already fragile Eurozone economy. In this respect, Draghi once again managed to generate a positive surprise.

The ECB took more credit easing measures than expected by pulling forward a private asset purchase program and buying a larger range of assets (which increases the potential size of the program).Combined with the TLTRO’s announced in June and a successful completion of the AQR and the stress tests, private QE should generate a significant reduction of bank and non-financial private sector funding costs as well as a further easing of credit supply. Nevertheless, it will take considerable time before the benefits of this process make themselves felt in the real economy. In the meantime, inflation expectations could well slide further.

With respect to the latter, it is very important that for the first time the ECB is now talking about targeting a certain size of its balance sheet. In theory, the balance sheet can be increased without limit and to anchor inflation expectations, it is of the utmost importance that the private sector be convinced that the ECB is willing to do “whatever it takes” in this respect.

Relying on the expected divergence of monetary policy cycles to do the heavy lifting via the implied depreciation of the euro is a risky strategy. It is much better that the ECB takes a pro-active approach fostering this depreciation and shoring up inflation expectations by taking control of its balance sheet. It is thus reassuring that the GC is unanimous in its determination to defend stable inflation expectations in this way.

However, what is less reassuring is that some GC members are not  yet convinced that the present balance of risks calls for such action. Because we believe there are not enough private sector assets for the ECB to buy to make a big enough impact on inflation expectations, we retain our view that the central bank will eventually be pushed into sovereign QE.

However, the risks that this will not happen are non-negligible. The ECB could “get lucky” if the current measures combined with a decrease in geo-political tensions generate a substantial increase in EMU confidence and spending growth which, in turn, stabilizes inflation expectations. Alternatively, the “deflation risk pain threshold” of the more skeptical GC members may be further away than we think.

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