The EU Economy Has Been Picking Up A Lot Of Steam. When Will The ECB Begin To Raise Rates?

Mar. 31, 2017 12:41 PM ETVGK, HEDJ, FEZ, IEV, EPV, EZU, SPEU, EURL, DBEU, EEA, FEP, HEZU, UPV, IEUR, FEEU, ADRU, FIEU, DBEZ, FEUZ, CHPT, HFEZ, HFXE, DEZU, FIEE, GSEU, HGEU, PTEU, RFEU1 Comment
D. H. Taylor profile picture
D. H. Taylor
8.27K Followers

Summary

  • ECB reiterates dovish stance, correcting markets misperception.
  • Inflation in Europe remains benign from core perspective.
  • EU economy has been picking up its pace lately, but that will not prompt ECB to change stance.
  • ECB should continue with QE throughout rest of year.

The European Central Bank (ECB) made certain that the market that originally perceived the central bank was getting hawkish understood otherwise: they are still dovish. The EURUSD has come down about 2 big figures since then, moving from 1.0800 down to about 1.0600. A few months ago the market was surprised by the ECB when the bank dropped their monthly asset purchases form €80 billion down to €60 billion as they were preparing to taper out the quantitative easing (QE) program. So, which is it? Is the ECB tapering and getting hawkish, or not? And, what does this mean for the EUR?

The best gauge to see where the ECB may stand is to look no further than the economy. First, from a historical perspective, the ECB has one policy: price stability. Whereas other central banks around the world marry price stability with full, employment, the ECB is very narrowly focused.

That narrow focus is not too limiting if you think about it. By focusing on prices you will ultimately get to employment gains or losses. If price pressures are well below target levels that I am willing to be there probably is not full employment. On the other side, once there is full employment price pressures are likely to start showing up. Although it is not necessarily limiting, it does seem a bit simplistic. Nonetheless, that is the goal of the ECB.

With price pressures falling rapidly and economic malaise in the EU, the ECB vowed to do "whatever it takes" to save the Union. That is when they brought in their quantitative easing (QE) strategy to purchases asset backed securities. They were driving interest rates downward.

Now, the European economy is picking up steam. There is manufacturing activity and there is wage growth. However, there is no real inflation on the core level, the preferred gauge of the ECB. Here is the manufacturing PMI charts for the Euro-Area. These charts are the same, the first the past 12 months, the second the past 10 years:

Manufacturing PMI is pushing higher. There is economic activity some of which we are just witnessing this week. This activity is happening around the world. The United States and Canada are both seeing expansionary economic activity, and so is Great Britain, even despite Brexit.

But, despite inflation in the headline inflation reports, there is hardly any inflation in the core rates. The headline recently printed 2.0% increase year-over-year. The core inflation rate printed a more benign 0.9%. My problem with this is that headline inflation affects products the general population purchases every day, such as food and gas, whereas the core rate leaves those things out.

Nonetheless, until the core rate pushes higher, the ECB is very likely to remain on the dovish side. They typically only target rates about 2.00%. With a core rate of 0.9% right now, that does not seem too far off. Given the economic growth we have right now, it is very possible that the inflation rate moves close to the 2.00% by the winter of next year. The economic activity Europe has is starting to be robust. That might push wage rates higher, which would propel consumption. That might be enough.

My best guess is that the ECB keeps their QE program going, on some level, until the end of the year. They may very well step in and surprise the market with further declines in their purchasing program this year. That will send rate higher, which are negative at this time. That will also send the EUR up sharply.

But, there may be limitations to how high the EUR will go versus its counterparts. The ECB was late to the dorm and will be playing catchup with their economic activity. But, I do see the EUR picking up ground against the USD and CHF to some degree. First, however, the interest rate needs to get out of negative territory.

This article was written by

D. H. Taylor profile picture
8.27K Followers
Author of: CannabisInvestingNewsletter.com where I focus on Cannabis stocks.I am an economist and mathematician having studied at the University of Denver. I trade my own account... I eat what I kill. I start my focus on the consumer and look at economic data to determine how strong the consumer is at any moment. From that, I extrapolate the state of the consumer and shopping trends at retailers as well as purchasing of housing and autos. I follow the major trends of these to determine the health of the economy here in America and abroad.I call California home but have a home in Mexico.

Disclosure: I am/we are short EURGBP. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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