Back at Sintra in mid-June when Draghi initially signalled that “in the absence of improvement” the ECB
would be prepared to ease policy, it was interpreted as a significant lowering of the bar for further
action. And with domestic activity treading water, global uncertainties persisting and the markets
anticipating further easing from the US Fed before year end, the question now is not whether the ECB will
add stimulus at its next meeting but what form that will take. What makes the ECB’s path more complicated
than before, however, is that while over the past few years the ECB and Fed were heading in the opposite
direction with one easing policy and the other tightening it, the circumstances have changed. In a sense,
the ECB may need to run harder than in the past just to stand still.
example, if the ECB fails to keep up with the Fed in terms of how aggressively it eases policy, the
spotlight could shift to the exchange rate. Alternatively, even if the Fed manages to hold the line on
rates, for the euro area economy, the euro’s move against the Chinese Yuan matters significantly more
than the moves against the US dollar or Sterling. And if US-China trade tensions escalate leading to
further CHY devaluation, then the euro area economy could end up facing a triple headwind of trade
disruptions, deteriorating sentiment and an appreciating currency even in a scenario where the moves
against the US dollar are kept to a minimum.
Finally, as the Italian political story moves on
to a new chapter, it’s obviously key that the sovereign bond market there continues to enjoy the support
of the domestic investor base. For example, during the last wobble in May/June 2018, foreign investors
cut their holdings of Italian sovereign debt by almost €60bn in two months. But over the same period, the
Central Bank added €7bn of paper through QE, ‘other financial institutions’ added over €22bn, and Italian
banks added €43bn.
Into year-end, however, traditionally, the Italian banks tend to reduce
their government bond holdings (before re-loading their positions in January and February). Therefore, if
political risk escalates, there may be questions as to whether the 2018 pattern of strong domestic buying
will necessarily be repeated. Much it would seem will depend on the support from the ECB and the
potential restart of QE … so no change there then.
The ECB should launch "significant and impactful" stimulus measures that surpass market expectations to
combat a slump in economic growth, Governing Council member Olli Rehn told The Wall Street Journal. He
added that the stimulus package to be announced at the Sept. 12 meeting should include key interest rate
cuts and "substantial and sufficient" bond purchases, as well as easing on the terms of new long-term
loans for banks.
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