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ECB to wind down QE, but dovish Draghi keeps options open

The dovishness of the European Central Bank even as it called an imminent end to its quantitative easing program contrasted with the U.S. Federal Reserve hawkishness of a day earlier, as ECB President Mario Draghi warned of an uncertain outlook for inflation and said that interest rates would remain unchanged for more than a year.

In a tale of two central banks the ECB President Mario Draghi is faced with the challenge of ensuring post-QE liquidity in European sovereign bond markets, uncertain macroeconomic data and stubbornly low core inflation.

In the press conference following a meeting of the ECB governing council in Latvia, he repeatedly stressed his "desire to retain optionality" and "maintain favorable liquidity conditions and an ample degree of monetary accommodation."

The decision to halve its asset purchases after September to €15 billion a month, and to end them after December, had been largely priced in by the market which was instead looking for clearer signals on interest rates hikes in the longer term and details about the ECB’s reinvestment policy for maturing bonds.

The ECB kept interest rates stable and guided that it expects them to remain at present levels at least through the summer of 2019 and for as long as necessary to meet inflation targets.

"The big story is the commitment not to raise rates for at least a year. It is this news that seems to be driving the euro and euro bond yields lower," Will Hobbs, head of investment strategy at Barclays Smart Investor, said in an email.

The market reacted with a drop of more than 1% in the euro and a boost for stocks with German exchange DAX and France’s CAC 40 up 1.68% and 1.39% respectively.

ING Germany’s Chief Economist Carsten Brzeski said the announcement makes a rate hike before September 2019 very unlikely. "The meeting marks another important step towards a gentle end to QE but at the same time, it does not mark the start of monetary tightening. A first rate hike is still far out."

The ECB tempered its outlook for growth following a slew of weaker data in recent months. The bank revised its growth outlook for 2018 to 2.1% from 2.4%, but maintained its estimates for 2019 and 2020 at 1.9% and 1.7%, respectively.

The inflation outlook proved more controversial among analysts with the ECB increasing its 2018 and 2019 forecasts to 1.7% from 1.4%.

Draghi was positive on the progress made toward reaching the sustained inflation target of 2% despite a lack of underlying growth in the core inflation, noting "we see the progress since 2015-2016 has been truly remarkable."

This surprised analysts who pointed to the dependence on energy prices, particularly the surge in oil prices at the start of the year, in pushing up the headline CPI inflation rate. Piet Christiansen, senior ECB analyst at Danske bank summed up the thoughts of many tweeting, "ECB must really be confident in wage growth."

Philippe Gudin at Barclays was more pessimistic on the long-term outlook. "We forecast core inflation at 1.1% this year and 1.3% next, while we see headline inflation at 1.7% in 2018 and slightly lower in 2019 at 1.5%."

Italy’s new populist government and burst of higher sovereign bond yields last month were not perceived to be a major threat with Draghi saying the impact was isolated and did not have the same potential for contagion seen at the height of the Greek crisis. "We shouldn’t dramatize changes of policies too much," he said.