Draghi Withholds Further Monetary Medicine on Recovery

European Central Bank President Mario Draghi is signaling the euro-area economy may not need another shot of monetary medicine.

Even as he acknowledged that the risks still lie to the downside, Draghi yesterday accentuated the positives of a recovery the ECB forecasts will strengthen enough to push inflation nearer toward its target through 2016.

The outlook, one month after Draghi said he needed more data before deciding whether to boost stimulus, was enough to persuade policy makers to leave the central bank’s key interest rate unchanged at a record low of 0.25 percent. The ECB’s stance may still be tested if investors react by driving the euro higher, with the ECB president indicating that a rising exchange rate is a potential threat toprice stability.

“Draghi actually sounds increasingly pleased with how things are going,” said Greg Fuzesi, an economist at JPMorgan Chase & Co. in London. “We continue to be open-minded about the ECB doing something small at some point, but it looks as if even this needs a material disappointment in the data.”

Draghi, who has cut interest rates five times and taken the ECB down unconventional policy routes since assuming office in November 2011, pointed to a flow of data suggested reason for confidence almost a year after the euro-area escaped its longest-ever recession.

Growth Signs

“Looking ahead, the ongoing recovery is expected to proceed, albeit at a slow pace,” he told reporters in Frankfurt. “In particular, some further improvements in domestic demand should materialize.”

Reports since the ECB’s February meeting showed gross domestic product in the currency bloc gained 0.3 percent in the fourth quarter, beating economists’ predictions on stronger expansions in Germany, France and the Netherlands and a return to growth in Italy. Economic sentiment rose to the highest level in more than 2 1/2 years last month, and services and manufacturing expanded the most since June 2011.

The ECB’s economic forecasts covered 2016 for the first time and predicted that inflation should be around 1.7 percent by the end of that year. That’s near the central bank’s goal of just below 2 percent and more than double last month’s rate of 0.8 percent. It projected growth will firm to 1.8 percent in 2016 from 1.2 percent this year.

‘Island of Stability’

Draghi also highlighted how the regional economy has withstood turbulence in emerging markets and instability caused by Russia’s military intervention in Ukraine. The currency bloc is an “island of stability,” he said.

The ECB “was obviously further away from a rate cut than we and several other watchers had assumed” said Joerg Kraemer, chief economist at Commerzbank AG in Frankfurt, which had predicted officials would reduce the benchmark rate and take the deposit rate negative. “The economic recovery is obviously the main reason why the ECB looks through the period of low inflation.”

Guillaume Menuet, an economist at Citigroup Inc. in London, is less sure that the ECB is done. He said multiple factors will combine to spur policy makers to ease policy again, possibly cutting the benchmark rate in April and the deposit rate in June.

“The persistence of a strong euro, weak credit dynamics, sizable slack -- capacity utilization and employment -- and indications of a gradual drift lower in long-term inflation expectations will need some monetary-policy response soon,” Menuet said.

Currency Strength

The ECB reduced its prediction for consumer price gains this year to 1 percent from 1.1 percent. The euro has strengthened more than five percent in the past six months, potentially eroding the competitiveness of the region’s exporters. The currency rallied to a more than two-month high as Draghi spoke yesterday.

While reiterating that the ECB doesn’t have a mandate to target the exchange rate, Draghi signaled that extended gains in the euro could become a concern. He noted that the currency’s rise since 2012 was responsible for a 0.4 percentage point reduction in the euro area’s inflation rate, calling that estimate a “significant statement on how the exchange rate might influence our price-stability objective.”

The ECB’s economic forecasts assume the euro averages $1.36 in each year through 2016. That compares with a current rate of about $1.38.

Forward Guidance

“The fact that Draghi explicitly mentioned the exchange-rate impact on inflation is in our view a clear signal that the ECB would not be pleased with a further strengthening of the euro,” said Carsten Brzeski, an economist at ING Group NV in Brussels.

Draghi didn’t rule out fresh action, listing lower interest rates, a pause in the sterilization of crisis-era bond purchases, action to revitalize the asset-backed securities market, and quantitative easing as potential options if the ECB needs to act again.

“We remain firmly determined to maintain the high degree of monetary accommodation and to take further decisive action if required,” he said, reiterating his forward guidance that the ECB will keep interest rates at “present or lower levels for an extended period of time.”

To emphasize his message, Draghi for the first time listed “the high degree of unutilized capacity” in the euro-area economy as an indicator to monitor alongside inflation, growth and monetary dynamics.

Wrong Call

“The ECB expects slack in the economy to fade very slowly, warranting very accommodative policy,” said Christian Schulz, an economist at Berenberg Bank in Frankfurt.

At the same time, Draghi’s upbeat comments suggest that, for now, little will change, according to Beat Siegenthaler, a currency strategist at UBS AG in Zurich.

“We thought that for once the ECB’s desire to sound dovish and talk down the currency would be stronger than the underlying institutional bias to stress the positives and downplay the negatives,” he said. “We could not have been more wrong.”