ECB likely to revise down 2016 inflation forecast significantly

ECB is largely expected to ease tomorrow. However, market expectations appear mixed, mainly due to the December experience and the uncertainty regarding with instruments to use. A cut of 10bp in the deposit rate looks very timid due to the threats to core inflation. Even if accelerating the asset purchases remains an option, the governors are expected to be worried regarding the future liquidity and a flatter yield curve and instead choose a 20bp cut in deposit rate. Also, the TLTRO is likely to be extended for one year. The corporate bond purchases program and expanded collateral eligibility continues to be a possibility but with restricted economic impact.

In spite of increasing proof that the threats to core inflation are increasing, the central bank's next course of action continues to be uncertain. Some feel that the ECB will take measures to calm market fears, particularly surrounding banks, probably by purchasing troubles bank assets or even bank bonds/equity. However, this is highly unrealistic. On the contrary, the ECB is likely to maintain pressure on banks in order to make them lend more amidst structural pressure to alter business models and increase efficiency.

However, ECB seems unlikely to succeed as it cannot do much to make consumers and corporate take credit if other factors weigh on the incentives to invest. Under such scenario, the central bank and regulators might be too positive on the macroeconomic impact, while there remains a concern regarding impacts, such as further bank deleveraging, tighter credit conditions and cash flows to insolvent companies rather than productive investment. Several Governing Council members are expected to want both accelerated asset purchases and a reduction in the deposit rate.

The Governing Council, under the current outlook is likely to err on the caution side. Lowering the deposit rate looks an easier option. ECB in its new forecast is expected to revise down the 2016 inflation outlook significantly to about 0.5%. However, it is expected to revise less for 2017.

"The new 2018 forecast is still likely to point towards the target (1.7%?, we have 1.5%). Similarly, the GDP growth forecasts are likely to be lower (we have 1.3% and 1.5% for 2016-17, the ECB had 1.7% and 1.9% in December) but not indicative of recession. Overall, the changes should signal a pushback in the recovery in inflation", says Societe Generale.