Our central expectation for the European Central Bank (ECB) meeting on 26 October is for the Governing Council to extend asset purchases by nine months at €30 billion per month to September 2018, without yet committing to a specific end date, while strengthening its commitment to keep policy rates and the balance sheet unchanged when asset purchases end next year.
Further out, we think the ECB will begin raising the deposit facility rate in mid-2019, starting with a 15-basis-point hike to −0.25%, followed by a gradual reduction of its balance sheet from 2020 onward.
Strengthening forward guidance
While de-emphasising asset purchases, we expect the ECB to re-emphasise rates guidance from prior meetings that “The Governing Council expects the key ECB interest rates to remain at their present levels for an extended period of time, and well past the horizon of the net asset purchases”, in order to minimise the risk of financial conditions tightening while it tapers. At the Peterson Institute conference on 12 October, ECB President Mario Draghi said the term “well past” is “very, very important in anchoring rate expectations.” Constructive ambiguity about the length of time “well past” equates to is more likely in our opinion than a calendar-specific commitment.
We expect the ECB to update and retain current language on asset purchases, stating they “are intended to run until the end of
December 2017 September 2018, or beyond, if necessary, and in any case until the Governing Council sees a sustained adjustment in the path of inflation consistent with its inflation aim.” Expect the ECB to also keep the obvious statement, “If the outlook becomes less favourable, or if financial conditions become inconsistent with further progress towards a sustained adjustment in the path of inflation, the Governing Council stands ready to increase the programme in terms of size and/or duration” – even if its self-imposed constraints mean it has limited ability to deliver on this promise.
We do not think the ECB will commit to a specific end date for asset purchases at this meeting. Based on current nominal growth trends and the government bond portfolio’s proximity to the 33% issue/issuer limits, we think purchases will stop at the end of September 2018. By cutting the monthly purchase quantity in half to €30 billion at this meeting, effective January 2018, the ECB can cease asset purchases in one go without having to slow them down in smaller steps towards zero over several months.
Other plausible term/quantity combinations for tapering asset purchases are six months at €30 billion or €40 billion per month, and nine months or 12 months at €20 billion per month. By the end of 2017 the asset purchase programme (APP) will have reached €2.28 trillion. Our baseline equates to an additional €270 billion in asset purchases, taking the APP to €2.55 trillion in 2018. While our scenario analysis suggests an additional €360 billion of purchases would be possible before the ECB’s government bond holdings reach the binding issue/issuer limits (implying a cap of €2.64 trillion for the APP), we see the risk as being less over a shorter period.
Risks of faster exit from extraordinary policy
Our baseline above lays out what we think the ECB will do. That said, in considering the distribution of possible outcomes around our baseline, four factors suggest the ECB may accelerate the exit and normalise policy faster:
- Leading indicators of nominal economic growth continue expanding and have reached levels where the ECB tightened monetary policy in previous cycles before the global financial crisis began, suggesting less accommodation is needed.
- The Phillips curve relationship between unemployment and inflation is changing in such a way that inflation tends to respond less to falling unemployment, for example owing to higher participation rates of older workers, technology and globalisation of supply chains. More highly accommodative monetary policy may just inflate assets prices further without generating consumer price inflation, posing a risk to financial stability.
- The ECB has limited ability to ease further and it would be desirable to rebuild policy flexibility before the next recession occurs. In our baseline, the ECB’s policy rate will still be close to zero and it will still hold a third of eurozone government bonds in 2020. Were the U.S. economy to grow uninterrupted until then, it would mark America’s longest business cycle expansion since 1945. Not impossible, but not highly probable. With eurozone growth dependent on exports, especially Germany’s, it will not be unscathed by a U.S. slowdown. Withdrawing policy support now – while global growth is strong and synchronised – would likely create greater flexibility when the inevitable next recession arrives.
- President Draghi’s term ends in October 2019. Putting monetary policy on a clear exit path before then will likely minimise the risk of a potential unwarranted tightening of financial conditions that could arise as a result of ECB leadership change.
Whether the ECB ultimately normalises policy faster depends foremost on the extent to which low inflation reflects either insufficient aggregate demand or positive supply-side developments. And dependent on that conclusion, consider what weight the ECB attaches to achieving 2% inflation at all costs versus risks to growth stemming from destabilising asset price bubbles. For now the ECB is an adamant believer in the Phillips curve, leading to its preference for macroprudential policies to counter asset price bubbles as it pursues a highly accommodative policy. A growing amount of evidence suggests the Phillips curve relationship is weakening and that risks to financial stability are growing.
With limited term premia in the front end of the yield curve, and risks tilted more to a hawkish than a dovish ECB outcome if our baseline is wrong, we expect to be slightly underweight duration overall, anticipating a fairly range-bound market but with the potential for a shift higher in yield in the context of our New Normal/New Neutral framework. The overall accommodative stance and strengthened forward guidance will likely anchor front-end rates, however, and we will look to fade any strong back-up in rates were they to materialise as a result of the ECB’s policy changes.
The Bundesbank has begun lengthening the duration of its portfolio as it approaches issue limits on shorter-maturity Bunds and we expect this trend will continue, supporting the long end of the Bund curve. We prefer using interest rate swaps or underweighting the long end of the semi-core and periphery government bond markets to achieve structural curve targets.
We think monetary policy will be broadly neutral for periphery-Bund spreads with less support from tapering offset by the capital key being applied to gross asset purchases, which should generate reinvestment flows that marginally benefit France and Italy owing to the higher share of Bunds held in the portfolio that will mature next year.