No decision likely this week

The comments last week from ECB chief economist Peter Praet that the central bank will at its latest policy meeting this Thursday, debate whether to end asset purchases later this year, has woken markets up to the possibility that a shift in policy is coming sooner than anticipated.

And this was after political uncertainty in Italy and soft Eurozone economic data had raised some doubts over whether the ECB would, as expected, be able to start tapering its bond purchases in 2018.

So what will the ECB do this Thursday? Judging by recent comments from central bankers, discussion about whether to end asset purchases this year will be on the agenda. Given that a shift is now widely expected, whether that announcement comes this month or next month is less important. It is also worth noting that this week’s meeting is an external one, in Riga, Latvia and not in the usual Frankfurt, which probably makes a key policy change announcement less likely. Furthermore, the ECB’s annual economic symposium in Sintra, Portugal, takes place next week, and ECB President Mario Draghi may use that event to give greater clarity on policy.

When will the policy shift actually come? For many economists, tweaks to the ECB’s so-called forward-guidance, which includes its outlook on asset purchases and interest rates, is more likely to come at the July 26 meeting than the June 14 gathering. The central bank will then likely details plans to wind up QE by year-end, while tempering market expectations for an early rise in interest rates. We think it likely that when QE details are eventually revealed, they will show a preference to reduce bond-buying by €10bn per month during Q4, allowing the programme to end in December. As regards interest rates, we expect forward-guidance to be updated and linked more directly to inflationary developments. At this juncture, we are not anticipating a rate-change until Q4, 2019 at the earliest.

Could the ECB still extend stimulus if it wanted to? The short answer is no, or not really without redesigning the scheme – something that is politically unviable when the economy is in decent shape and inflation is picking up. The ECB faces a scarcity of eligible bonds it can buy for its unprecedented €2.55 trillion stimulus scheme, strengthening the case for a taper sooner rather than later. Yet, the question of whether to extend bond-purchases gained ground recently as some investors cast doubt on the ECB’s QE exit strategy given the spike in Italy’s borrowing costs. Another way that has played out is in a scaling back of investor rate-hike bets – although these have come back following the recent hawkish ECB comments. Money market pricing suggests investors price a rate-increase by September next year.

How could Italy impact the ECB’s exit plans? One way or another Italy is likely to come up, if not at the meeting itself, then at Mario Draghi’s press conference afterwards. Some calm has returned to Italy’s bond market with the risk of fresh elections averted for now, and with the vow over the weekend from new Economy Minister Giovanni Tria to keep the country in the euro and to cut its debt level. But uncertainty emanating from Rome is far from over. That brings into question the ECB’s role should the bond market buckle again. The most recent data showed that the ECB slowed its purchases of Italian government bonds in May, just as investors were offloading them. The central bank has tried to counter accusations in Italy that it had deliberately bought less Italian debt to influence the formation of a new government. Italy is one of the biggest beneficiaries of QE and tapering couldn’t come at a worse time for a beaten-down bond market.

Will the ECB declare victory over inflation? Stubbornly low Euroland headline inflation jumped by more than expected to 1.9% in May, lifting price growth to within the ECB’s targeted range. Policymakers say inflation needs to return to a level of below but close to 2% before it winds down QE and raises rates, so May’s data raised expectations that an end to ultra-loose monetary policy is on its way. The central bank is also likely to take comfort from the fall in the euro, which is down over 1% on a trade-weighted basis since its April meeting. But “core” inflation, which strips out volatile food and energy prices, and which is keenly watched by the central bank, rose just 1.1% last month on an annual basis. The ECB says it looks past oil price shocks, even though they eventually feed through to headline inflation. In short, the ECB will want to see target price growth persist for longer than a single month before the battle to increase inflation can be declared won.

Alan McQuaid (11/6/18)
Economist