Moving in tandem

All eyes next week will be on the Federal Reserve and the ECB.

The Fed is almost certain to raise rates again on Wednesday, inching closer to a neutral policy stance, while the European Central Bank may signal on Thursday that its €2.55 trillion bond-purchase scheme will end this year, a key move in dismantling crisis-era stimulus.

For the ECB, the next step is likely to be another in a series of incremental moves, as policymakers seek to avoid any potential backtracking, mindful of their two disastrous rate-hikes in 2011, which exacerbated the Eurozone’s debt crisis.

The Euroland economy has been growing for over five years, employment is at a record high, wage inflation is increasingly clear and bond purchases have done all they could to cut borrowing costs, making ending the scheme the logical next step.

The ECB has already said the asset purchase programme’s fate will be on the agenda on Thursday, but ECB President Mario Draghi must decide whether to declare the end or wait until policymakers next meet in July. The end of quantitative easing raises a tricky issue for the central bank: interest-rate hikes are tied to the end of the purchases, with the bank’s guidance stipulating that rates will stay unchanged “well past” the programme’s conclusion.

With no purchases into 2019, more specific guidance will be needed to keep rate-hike expectations anchored and to give the ECB flexibility to delay if needed. It is expected to opt for a formula that specifies steady rates for several quarters and for as long as rates are consistent with the central bank’s near 2% inflation target.

But with growth slowing and “peripheral” bond yields on the rise due to fears of political instability in Italy, downside risks appear to be increasing, suggesting to some that the ECB may try to get out early to avoid being dragged into politics. Some countries may have an interest in reducing the support to a populist government. After all, the QE programme also entails buying Italian government bonds.

Some have even argued that the ECB may opt for a June decision because it fears bond market turbulence later that would make a July move more difficult. But, accelerating the end-date announcement due to fears of an even more clouded economic outlook later on, fuelled by policy uncertainty, would in our view do little to enhance the ECB’s credibility.

For the Fed, raising rates by 25 basis points to a range of 1.75% to 2.00% appears an easy call. The US central bank is meeting both of its objectives — its preferred inflation rate is at 2% and the economy is at full employment. The question is whether its rate-hike projections — three moves both this year and next — move up and whether it expects to hit the so-called “neutral” interest rate quicker than earlier thought.

The domestic risks facing the US economy are arguably tilted to the upside. A significant amount of fiscal stimulus is coming on stream when the economy is by many measures close to full capacity, and growing at an above-potential pace.

An overheating labour market would argue for quicker tightening, but inflation is expected to stabilise around target, and the Fed is likely to be careful in any move above the “neutral” rate, which neither stimulates not cools the economy.

Another issue to watch will be the US central bank’s assessment of the growing external risk from an increasingly long list of sources, like a global trade war, or sovereign risk in places like Italy, Turkey or Argentina.

Alan McQuaid (8/6/18)
Economist