Something’s up in Europe. And if the situation continues, more things may be up in a year’s time. Growth is up; 2017 probably saw the strongest pace of economic expansion in the euro area since 2011. Despite this, the consensus view has been that the European Central Bank (ECB) will continue its asset purchases until at least September 2018, and policy rates will not rise before mid-2019. But it seems that the common wisdom has been wrong. Recent ECB communication suggests that the emergency policy setting is no longer warranted and, this time next year, the central bank may already be gearing up for its first policy-rate increase.
Certainly, a quick look at euro area economic data suggests that the time for extraordinary monetary policy measures must be behind us. In January, the composite PMI (a business activity indicator) rose to its highest level since 2006. The German Ifo business-climate indicator hit a record high in November. Euro area consumer confidence is only a touch below the all-time high recorded in 2000. And in the 12 months leading up to November, the euro area unemployment rate experienced the largest decline in the history of the European Monetary Union.
Given the impressive economic performance, why has the outlook for the ECB been so dovish? There are three reasons:
- Inflation – It has remained stubbornly below the 2% target. Current ECB core inflation forecasts predict only a slow climb to 1.3% by year-end 2018. But, the ECB appears to have become slightly more confident about the inflation outlook and could revise its forecasts up.
- The euro – The ECB has previously emphasized its concern about its strength. The trade-weighted euro is up 1% to 1.5% since mid-December, and this gain will likely further weigh on inflationary pressures. On the upside, however, the ECB may now be less concerned if it judges that the stronger currency reflects a stronger euro area economy.
- Lessons from the Federal Reserve (Fed) – When the Fed stopped asset purchases in 2015, the global economy was lackluster, the U.S. dollar was strong, and inflation was subdued. As a result, the Fed wasn’t ready to raise rates for over a year. But times have changed. There is currently a strong synchronized global economic expansion and the euro area is enjoying its strongest economic performance in seven years.
Given the exuberance of the euro area economy and recent ECB communications, the market has adjusted its expectations and is now pricing in the first rate hike in March 2019. On its own, this information doesn’t change the positive 2018 outlook for European risk assets, it simply reflects a stronger economy. What’s more, the rate normalization process is still likely to be very gradual – estimates suggest that the ECB may not reach a neutral nominal interest rate until 2022.
Higher inflation and more hawkish ECB communication may, however, result in greater volatility in 2018 and increase asset markets’ vulnerability to shocks. What’s more, if inflationary developments force the ECB to raise rates even sooner (because of, say, a continued climb in oil prices), the impact on global bond yields could be quite severe, threatening the very impressive bull market run that we have been enjoying…
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