The latest ECB staff macroeconomic projections for the euro area were released in March. The ECB then revised headline inflation expectations upwards to 1.7% on average over 2017-2019. Energy prices are expected to account for 1.2 percentage points of the inflation strengthening in 2017. At the same time, the 'core' inflation that excludes volatile components such as energy and food, is expected to grow at a much slower pace. The ECB estimates that 'core' inflation will increase by 1.1% on average through the course of this year and 1.5% and 1.8% in 2018 and 2019 respectively.
After an improvement in March and April, the eurozone inflation decreased from 1.9% in April to 1.4% in May. Furthermore, the 'core' inflation declined from 1.2% to 0.9%. Such movements suggest that the 2017 ECB inflation estimates might be too high. Moreover, at its press conference in April, Draghi stated:
"A very substantial degree of monetary accommodation is still needed for underlying inflation pressures to build up and support headline inflation in the medium term. If the outlook becomes less favorable, or if financial conditions become inconsistent with further progress towards a sustained adjustment in the path of inflation, we stand ready to increase our asset purchase program in terms of size and/or duration."
Markets are currently expecting the ECB to announce further tapering of its quantitative easing as soon as in autumn. The latter is in line with the existing requirements of not holding more than one third of certain countries' outstanding bonds. Also, markets expect that the ECB will have a somewhat more optimistic rhetoric as soon as on tomorrow's meeting.
In my view, it is really doubtful how far will the ECB be willing to retreat from an easing bias after such disappointing inflation data. After all, they committed themselves to proceed with the current pace of monthly bond purchases until the end of this year at least so they have enough time to prepare the market for tapering somewhat later this year. In addition, on the latest press conference Draghi said:
"…easing biases are actually linked to inflation. In other words, the easing biases are meant to cope with tail risks concerning the inflation rate, not growth directly. It's quite clear that as growth perspectives improve, certainly the probability of these tail risks may go down, but we are not there yet."
Clearly, the ECB will not consider the recent improvement in growth prospects enough to remove the easing bias while inflation pressures are staying subdued.
The recent euro appreciation against the dollar largely owes to the aforementioned market speculations of ECB tapering announcements. Also, markets started speculating that ECB might opt for an interest rate rise before ending the bond purchase program. I found the latter highly unlikely. Draghi himself stated at the end of April that they continue to expect that interest rates will remain at present or even lower levels for an extended period of time.
As the ECB is fully aware of the current overly optimistic market stance, I believe that they will give their best to once again highlight that they have no intention of an interest rate increase for the time being. Also, given the recent inflation disappointment, the ECB is very likely to sound less optimistic than markets currently expect.
In such circumstances, the euro is set to erase some of its recent gains versus other currencies. However, we must not forget that former FBI Director James Comey's Congressional testimony is scheduled for the same day. The impact on the EUR/USD will depend on both events, so I would prefer shorting the euro versus the yen or Swiss franc than the dollar.
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