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Euro jumps as ECB declares victory against deflation

Mario Draghi has declared victory against deflation and moved a step towards ending the European Central Bank’s ultra loose monetary policy, sending the euro and German bond yields higher as investors bet on the end of crisis-era stimulus measures.

Facing growing pressure from monetary hawks in Germany, the ECB president said the bank decided to change its guidance to investors — omitting a reference to using all the weapons in its policy arsenal — because of its success against a destabilising bout of falling prices.

Though the ECB agreed to keep interest rates at record lows, Mr Draghi said the bank no longer had a “sense of urgency” to take further action on monetary stimulus and that policymakers “do not anticipate that it will be necessary to lower rates further”.

Investors viewed the remarks as a sign the ECB was preparing to pare back its historic bond-buying programme, begun two years ago to drive down borrowing costs across the eurozone as a way of stimulating the real economy.

The euro rose 0.7 per cent to hit a weekly high of $1.0615 on Thursday and the yield on the benchmark 10-year German Bund reached their highest levels since early February at 0.42 per cent. By early afternoon in Hong Kong the single currency had edged up a further 0.2 per cent to $1.0601.

Frederik Ducrozet, senior Europe economist at Pictet Wealth Management, said investors had been poised to react to any hints about scaling back stimulus. “We know it’s coming, but we don’t know when.”

The ECB shift came as eurozone inflation rose above its target of just under 2 per cent for the first time in four years, levels that increased pressure on the ECB from its German critics to tighten policy. Low interest rates have become politically toxic in Germany, where they are seen as helping struggling southern eurozone members at the expense of German savers.

In Thursday’s closed-door meeting, a group that included members of the ECB’s executive board and heads of the German, Dutch, French and Spanish central banks called for Mr Draghi to focus less on the bank’s readiness to step in and offer more stimulus. They urged him to shy away from any remarks that would signal he believed the recent rise of inflation could peter out.

Speaking to the press after the meeting, Mr Draghi said the ECB was not planning to unleash another round of cheap bank loans and that, because of the improving economy, he had dropped a sentence from his remarks that referred to the ECB’s willingness “to use all the instruments available in its mandate”, if warranted.

While this was a more subtle shift than hawks on the council had wanted, it was more aggressive than markets had expected.

Markets are now pricing in a 68 per cent chance that the ECB will raise interest rates by August 2018 — up from 31 per cent last week.

The bank has made clear for months that it will only raise interest rates after it winds down its €60bn-per-month bond-buying programme, which is scheduled to run until at least the end of December.

“The message was very subtle,” said Cathal Kennedy, European economist at RBC. “It was just a nod that lower rates have been taken off the table. But it has been taken as a signal that the era of extraordinary stimulus is coming to an end.”

Concerned about markets overinterpreting the shift in the bank’s mood, the ECB president was careful to avoid any mention of the bank tapering back its asset programme.

The ECB president cautioned that while “the risks of deflation have largely disappeared”, he was not yet ready to “pronounce victory on the inflation front”. For that to happen, Mr Draghi said, pay for the region’s workers would need to grow at a faster pace.

“Wages growth is the linchpin of a self-sustaining rise in inflation . . . that is the key variable,” he said, later adding: “It’s not the only point, but it’s an important element of our assessment.”

He also said increasing headline inflation in the eurozone was largely driven by high energy prices, with core inflation remaining at only 0.9 per cent.

In a spirited defence of the bank’s ultra loose stance, Mr Draghi highlighted steady quarter-on-quarter growth since 2015, a fall in unemployment to the lowest level since 2009 and the most buoyant economic sentiment since 2011.

The ECB’s headline inflation forecasts were upgraded for this year, to 1.7 per cent, from 1.3 per cent in the previous quarterly forecast. The ECB made no change to the forecasts for succeeding years — 1.6 per cent in 2018 and 1.7 per cent in 2019. The bank’s forecasts for growth were also little changed at 1.8 per cent in 2017, 1.7 per cent in 2018 and 1.6 per cent in 2019.

The council left the benchmark main refinancing rate at zero. The deposit rate levy charged on a portion of reserves parked at central banks in the region remained at minus 0.4 per cent.

Additional reporting by Mehreen Khan in London

Via FT