Barclays Economics Research
The euro has appreciated by c.9% on a trade-weighted basis (NEER) over the past six months. The minutes of the July ECB meeting mentioned the “risks of exchange rate overshooting”. However, when President Draghi was asked at the July press conference whether the euro appreciation was a concern, he responded that “financing conditions remained broadly supportive to secure a sustained return of inflation rates towards our inflation aim”. Financing conditions do remain supportive by our estimates; but the significant euro appreciation undoubtedly brings downside risk to inflation, while slightly boosting growth. These risks have monetary policy implications.
- Financing conditions: Our in-house financing conditions index, which encompasses market, credit and monetary conditions indicators, at an aggregate level, has not tightened in 2017 and remains supportive of economic activity in the euro area. The tightening of the conditions resulting from the euro appreciation has been compensated by the easing of other variables, notably the increase of the ECB balance sheet and the tightening of real bond yields.
- The inflation outlook: Our latest update of the inflation outlook is mindful of risks stemming from the recent sharp euro appreciation. Using both a bottom-up (inflation subcomponents) and top-down analysis (VAR), we estimate that a 9% NEER appreciation implies a cumulative reduction in euro area inflation growth of 0.3pp over the next 12 months. Assuming no further appreciation of the euro, we forecast HICP and core inflation to average 1.2% in 2018.
- Growth: We expect growth in the euro area to average 2.0% in 2017-18. We forecast that most of the growth will come from domestic demand components and about a third of it from investment. The contribution from net exports will be significant this year (+0.5pp) but smaller in 2018 (+0.2pp). The risks to our growth outlook, including the effect of the past currency appreciation, remain broadly balanced as we are not expecting a significantly larger trade-weighted appreciation of the euro from current levels and expect monetary policy to remain very accommodative in 2018.
- Monetary policy: The Governing Council is due to revise the degree of monetary policy accommodation this autumn. The recent euro appreciation is an important factor that the GC will have to take into account in its decision-making process. Prudent risk management would call for the ECB to keep its QE options open in 2018. We therefore retain our baseline policy view. This autumn, we expect the ECB to extend QE to H1 18 at a reduced pace of EUR35-40bn per month. This would be followed in 2018 by a further extension of QE at a pace of EUR15-20bn. We also expect the ECB to deliver in June and December 2018 a depo rate hike of +10bp each. In sum, throughout 2018 we still expect QE and negative rates, but both at a less accommodative level than in 2017.