ECB Lowers 2018 Inflation Forecast To 1.3%

The stock market was up modestly on Thursday after the big news surrounding the Comey testimony and the ECB statement were released. It’s now focusing on the U.K. elections which will affect Friday’s trading. The market has been so quiet, small moves that these events cause look like big moves because volatility has vanished this year. In terms of the stock market’s intermediate term moves, this political news is mostly hot air. I’m not saying it doesn’t matter to you, but it doesn’t matter to stocks which should trade based on their future cash flows.

As I predicted, the ECB didn’t cause much movement in the stock market, but it was very important. There were surprises in the statement. I can see the logic behind them, but they weren’t my base case expectations. The chart below shows the changes in the ECB’s forecast for GDP growth and inflation. The changes in GDP growth are not surprising. The initial expectation for 1.8% seemed high at the time it was made, but now it seems low. I think these GDP expectations are like a dog trying to chase its tail. Expectations only increased because Q1 was great. If the forecasters didn’t predict Q1 was going to be as good as it was, how will they predict how good the rest of the year will be? These predictions are meaningless in terms of accuracy, but we must watch them because they effect central bank policy.

The HICP inflation expectation changes were the surprising part of the June meeting. As you can see, the 2017 expectations were lowered by two tenths, the 2018 expectations were lowered by three tenths, and the 2019 expectations were lowered by one tenth. The base case expectation was lowing them each by one tenth. The 1.3% inflation expectation for 2018 is the lowest expectation in the history of the metric.

Analysts are saying that the inflation expectation for 1.5% ruins the ECB’s credibility because inflation was at 1.5% before QE was started. I disagree with this assertion. There are two types of credibility. The first is whether the ECB will act on what it says it will do. ECB president, Draghi’s “whatever it takes” statement has been backed up by an enormous amount of QE. The ECB’s balance sheet is larger than the Fed and the JCB’s balance sheet.

The second type of credibility is whether the QE will work. In terms of lowering Italy’s government bond rates, it was worked. It has helped stabilize the Italian banking system which would be in dire straits without ECB help and government bailouts. The absolute best approach would be a capitalist managed bankruptcy, but that is like trying to fit a square peg into a round hole. The Italian system isn’t capitalist, so it isn’t possible.

The second way economists and the ECB gauge whether the ECB’s asset purchases are working is to see if inflation is increasing. It’s objective fact that QE hasn’t caused inflation in the U.S. or Europe. I don’t think a few tenths of one percent change in a forecast matters in terms of figuring out if QE causes inflation and if the ECB has credibility. The only reason why this is mentioned is the ECB can claim credit for token increases in inflation if it’s up, but can’t if it’s down. The ECB can claim whatever it wants, but the fact remains that if inflation was increasing it wouldn’t be because of QE. To expand on that point, since the ECB has been ignoring reality for months, I don’t see why the ECB can’t still go along with the claim that QE causes inflation. The principle behind cutting back on QE was that inflation was coming close to the 2% limit. That was always a confusing principle because QE isn’t pushing inflation higher.

The chart below shows the ECB’s balance sheet, repo rate, and the deposit rate. The ECB got rid of its guidance that it might cut rates. That is likely the response to higher than expected GDP growth. On the other hand, the bigger news was that the ECB did not discuss scaling back the bond purchase program. This caused the euro currency to fall to 1.1216 versus the dollar. This is dangerous in my view because the ECB is viewing the low inflation rate as cover to keep up with QE. The QE never caused inflation in the first place, but now that other factors have lowered inflation, such as the supply and demand dynamics for various commodities, the ECB is ready to keep going. This policy statement was more dovish than the market expected and more dovish than I expected.

This means the critics of QE were right. They claimed that once central banks started QE, they can’t stop doing it. This thought process is behind my skepticism of the Fed’s unwind which is expected to start later this year. As a reminder, I have two forecasts. I have a forecast based on what the central bankers say and a forecast based on what their actions have been. I mainly discuss their policy statements because my expectation that the central bankers will always lean towards expanding their balance sheets is speculation. It’s educated speculation based on the fact that all the major central balance sheets look like the ECB’s in the chart above. They go from the bottom left to the top right of the chart.

As I mentioned, the logic that the ECB will not stop its buying makes sense if you go along with the logic that QE causes inflation. The question many readers are wondering is what this dovish change means for the U.S. markets. The answer to that question lies in the chart below. It shows the U.S. Macro Surprise index and the Bloomberg Financial Conditions index. As you can see, financial conditions have been easing since the summer of 2016 despite the Fed’s hawkish tone. The ECB’s QE helps ease financial conditions. The global central banks got together and stopped the 2016 recession. Now the ECB is keeping its foot on the gas pedal. This is bullish for stocks in the next few months.

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