…As Policymakers Say Decision On When To End Program Could Come Next Week
Apparently, the deceleration in eurozone economic activity in Q1 and the political turmoil in Italy isn’t enough to prompt the ECB to take next week’s meeting off the table when it comes to making a potentially momentous announcement about when APP will ultimately be wound down.
Reports on Tuesday confirmed that next week’s pow wow is indeed “live” and that gave the euro a boost. Well fast forward to Wednesday and a trio of ECB officials were out noting that the debate will be front and center next week.
There was Chief Economist Peter Praet, who said “it’s clear that next week the Governing Council will have to make the assessment on whether the progress so far has been sufficient to warrant a gradual unwinding of our net asset purchases.”
There was Weidmann who, in a video call following Praet’s speech, said the following:
It doesn’t come as a surprise that for some time now, financial market participants have been expecting net asset purchases to end before 2018 is out. As things stand, I find these market expectations plausible.
This will be the first step on a long path towards monetary policy normalization. Inflation is now expected to gradually return to levels compatible with our definition of price stability.
Then there was Klaas Knot (who back in January was a bit reckless with the hawkishness) who told Dutch members of parliament in The Hague that “it’s reasonable to announce the end of the net asset purchases soon.”
All of that has the euro at a two-week high:
This raises further questions about whether they’ve missed their window and now think they’re behind the curve. That is, clearly the outlook has deteriorated both on the economic front and on the political front (in Italy), and it seems like they feel like they don’t have the luxury of waiting around to see if the Q1 deceleration was indeed “transitory” or to see if Italian assets have truly stabilized.
Of course critics can’t have it both ways, either the ECB needs to get on with this now in order to avoid quantitative failure in the event the economy continues to decelerate (you don’t want to run into a downturn with no progress made on normalization) or they don’t. You can’t very well shout at them to move faster and then implore them to slam on the brakes now that the economy looks like it might roll over because after all, another downturn will come sooner or later, that’s how cycles work.
As far as the Italian situation is concerned, that looks like it might be all set to flare up again as markets continue to sweat after Giuseppe Conte’s first speech as Italian PM tipped many of the same policies that had everyone concerned in the first place.
Whatever the case, next week will obviously be crucial. If Draghi simply uses June as an opportunity to tip July, that’s going to be seen as something of a dovish relent, but if he goes ahead and slaps a sell-by date on APP, well then the countdown is on.
For now, just let me leave you some passages from a recent BNP note that underscores what happens if they don’t replenish the ammo in time for the next serious downturn.
Let’s turn to the eurozone and the challenges it may face if a recession hits, where we assume this is US-led. Global trade growth would of course suffer, which would hit the open eurozone economy hard, leading to lower investment and employment. The first reaction in the last downturn from eurozone policymakers was to assert that the US problem would not affect Europe much. Hopefully they have learned and will move more quickly than last time. But what can they do? Core inflation is only 1% in the eurozone and while we forecast a rise to 1.6% by end-year, inflation expectations seem less stable in the eurozone than the US. We might see inflation fall more quickly than the US in a downturn. The current deposit rate is -40bp and looks unlikely to reach zero, in our view, until the end of 2019 at the earliest. This would leave the ECB with very little rate ammunition to stabilize the economy.
The problem could become more severe if the euro were to appreciate on the foreign exchanges. While the dollar might rise in a risk-off scenario against emerging market currencies and commodity exporters, there is a good chance that the JPY, CHF and EUR would be seen as “safe havens”, at least to start with. Given the large outflows from the eurozone in recent years and the tendency for funds to flock home in a crisis, the EUR could appreciate, hitting activity and dampening inflation. A return to negative rates would be likely in our view, though will -40bp be a deep enough cut? We doubt it.
This is because the last two cycles have seen a eurozone output gap of 2-2½% of GDP open up, according to the IMF. A repeat from current levels (where the output gap is close to zero) would require cuts in rates of 1% to 1¼%, according to the Taylor rule. Moreover, if experience of the great recession and the euro crisis is a guide then core inflation might fall by 1% or so, requiring, according to the Taylor rule, cuts of another 150bp. Thus a recession could require rates to be cut to -250bp. This hardly looks feasible.
A return to QE would look all but inevitable, though for several countries ECB holdings of bonds are close to the 30% limit the ECB has set itself. There is a high probability this limit would be lifted – maybe as far as 50%. Along the way, legal challenges to the ECB breaking the monetary financing rule would be likely, even more so if the 50% barrier were crossed. Purchases of other assets would come into question, as the ECB’s Mr Cœuré has suggested.
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