European Affairs

As Europe’s Recovery Accelerates, ECB Ratchets down Stimulus - No “Taper Tantrum” after Widely Expected “Lower for Longer” Announcement     Print
By James D. Spellman, Washington, DC

Spellman 1Europe’s central bank announced last week it will taper its unprecedented stimulus by reducing purchases of debt (“lower for longer”) and holding interest rates steady, tactics calibrated to support Europe’s accelerating recovery, curtail the euro’s recent appreciation, and stoke inflation’s embers.

The Frankfurt-based institution will cut its monthly purchases of government and corporate bonds by half starting in January to $35 billion (€30 billion) and continue that pace until at least through September next year. Nearly three years ago, the bank began buying assets, including public and private bonds, to stabilize the euro, hold interest rates low, and pump more money into the economy. These “quantitative easing” measures augmented the negative interest rates the bank had set.[1]

All these measures were aimed at fulfilling the pledge of ECB President Mario Draghi to “do whatever it takes” – the so-called bazooka option – to avoid asset deflation and turbo-charge Europe’s economy in the wake of the crippling global financial crisis.

CHART: ECB ASSET PURCHASES, IN TRILLIONS (EUROS)
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Source: Elliot Bentley, Martin Burch, Pat Minczeski and Christopher Whittall, “What ECB Stimulus Has Done.” Wall Street Journal, October 29, 2017. www.wsj.com .


CHART: EUROSYSTEM HOLDINGS UNDER THE EXPANDED ASSET PURCHASE PROGRAM
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Source: ECB. https://www.ecb.europa.eu/mopo/implement/omt/html/index.en.html#abspp .

Scaling back the debt purchases – the so-called “recalibration” – again demonstrated the mastery of Draghi in negotiating the straits between the hawks, wanting a more aggressive retreat of “easy money” to avert an asset-inflation bubble, and the doves, wanting to down-throttle more slowly to ensure the recovery isn’t impaired.[2] Both camps will become more vocal as members of the bank’s governing board position themselves to be candidates for Draghi’s job before he leaves on November 1, 2019.[3] (Germany Bundesbank President, Jens Weidmann, a hawk on monetary policy and a leading contender for Draghi’s job, criticized the ECB’s announcement the next day in a public speech about the future of Europe’s monetary union. “From my view a clear end of the net purchases would have been appropriate.”)

The "monetary policy decisions were taken to preserve the very favorable financing conditions that are still needed for a sustained return of inflation rates towards levels that are below, but close to, 2%," Draghi said at last Thursday’s (October 26) press conference after the decision. "The recalibration of our asset purchases reflects growing confidence in the gradual convergence of inflation rates towards our inflation aim, on account of the increasingly robust and broad-based economic expansion, an uptick in measures of underlying inflation and the continued effective pass-through of our policy measures to the financing conditions of the real economy."

The zero interest policy was left unchanged. Draghi said rates will remain “at the present level for an extended period of time, and well past the horizon of our net asset purchases.” ECB observers believe that means interest rates will not budge until 2019 if current trends continue.

Absent was any mention of how the ECB eventually planned to reduce the size of its balance sheet, or what it will do with proceeds from the maturing bonds it holds. These resources will cushion the bank’s slow move away from an era of easy money.

Draghi stressed the bank’s flexibility in its steps ahead, noting that the strength of Europe’s rebound, the inflation rate (almost two percent is ECB’s target), and the euro’s value will all be monitored closely in determining what the ECB will do next. The bank is "ready" to increase bond buying "if the outlook becomes less favorable, or if financial conditions become inconsistent with further progress towards a sustained adjustment in the path of inflation.”[4]

In response, the euro slid 1.4 percent against the dollar on the day of the announcement, its biggest daily decline in European trading since the U.K.’s Brexit vote last year, the downward move wiping out all of the euro’s gains from the quarter’s start. That eased concerns that the euro’s ascent was threatening export demand and could undermine Europe’s recovery. Bonds, though, rallied, with the yield on the German 10-year Bund falling 4 basis points to 0.44 percent. Germany’s bonds constitute the largest ECB holding of sovereign debt. Lower interest rates in the bond market take pressure off the ECB to do more to hold down interest rates.

CHART: ECB’S BONDHOLDINGS
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SOURCE: Michael Hunter, “Eurozone bonds rally as ECB extends bond buying.” Financial Times, October 26, 2017. www.ft.com .

“The ECB´s Asset Purchase Program (APP) served in several ways as a safety net by providing liquidity to the banking sector, keeping sovereign bond spreads low, lowering the external value of the euro, and keeping asset prices at elevated levels. In addition, bank failures in several member states were contained,” said Professor Dr. Timo Wollmershäuser, Head of Business Cycle Analysis, the ifo Center for Business Cycle Analysis and Surveys.[5]

The slower, lower approach addresses a growing challenge for the ECB, finding high-quality sovereign debt to buy. Issuance of such bonds was running seven times below the rate of ECB purchases, and investor demand for Triple A assets, such as Germany’s bonds, is high, according to research by Deutsche Bank.[6] The ECB’s purchases of government debt is also constrained by the bank’s own limits. Its holding of overall public debt cannot exceed one-third of its capital and it can only hold up to one-third of each country’s debt issuance. These constraints were installed to avoid violating Maastricht treaty prohibitions on the ECB financing EU member states.[7] An additional constraint was the limits on maturities (between two and 30 years) and yields (above the deposit rate of minus 0.4 percent),[8] but the ECB lifted the interest rate barrier in December last year.[9]

Even though the program will be cut in half next year, economists estimate the ECB will hit a barrier in the amount of bonds it can buy, even at the reduced level, especially for Europe’s largest economy, Germany, if the restrictions aren’t relaxed further.[10]

CHART: ECB BOND PURCHASES ARE SEVEN TIMES NET ISSUANCE
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SOURCE: Deutsche Bank Research cited in: Piotr Skolimowski, “Here’s Why the Stakes Are Higher for the ECB’s QE Exit.” Bloomberg, October 20, 2017. https://www.bloomberg.com/news/articles/2017-10-20/here-s-why-the-stakes-are-higher-for-the-ecb-s-qe-exit .

CHART: MORGAN STANLEY: ECB BALANCE SHEET UNLIKELY TO SHRINK FOR A LONG TIME


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SOURCE: Morgan Stanley. Cited in: Piotr Skolimowski, “Here’s Why the Stakes Are Higher for the ECB’s QE Exit.” Bloomberg, October 20, 2017. https://www.bloomberg.com/news/articles/2017-10-20/here-s-why-the-stakes-are-higher-for-the-ecb-s-qe-exit .

Several academic studies show that the ECB’s efforts had two effects on sovereign debt: lowering yields generally and repricing risks, meaning investors were more comfortable in investing in the debt of Italy and Spain, for example, since the ECB’s purchases lowered the risks of these debt-burdened countries (“repricing of risks).[11] Stock price increases were part of the spillover benefits, too.[12]

Europe is experiencing the best growth momentum in a decade, but inflation – remaining at 1.5 percent ̶̶ remains stubbornly below the ECB's target of “almost“ 2.0 percent. Forecasts see inflation staying below that target until at least 2019. Average full-year growth for the eurozone is forecast at 2.2 percent this year after long-term projections for the largest economies were revised upward.[13] Eurozone factory, mining and utility output surged in August; industrial output increased by 1.4 percent in August from July, and was up 3.8 percent from a year earlier, Eurostat said.[14] The European Commission’s monthly measure of sentiment rose to minus 1.0 from minus 1.2 in September, its highest level since April 2001.[15] More positive news is expected Tuesday (October 31) when Eurostat is expected to announce GDP quarter-to-quarter growth of 0.6 percent, slightly down from the 0.7 percent pace in the previous quarter. Unemployment is expected to fall, too.

CHART: REAL GDP IN THE EURO AREA (SEASONALLY AND CALENDAR ADJUSTED)
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SOURCE: ifo Center for Business Cycle Analysis and Surveys. http://www.cesifo-group.de .

Against this backdrop will be maneuvering by ECB board members and the leaders of member states to secure Draghi’s position. Germany’s Chancellor Angela Merkel has been lobbying hard for Weidmann, according to press accounts.[16] Weidmann is seen as a hawk on monetary policy, having opposed many of the bank’s stimulus policies. The “ECB president is one of a handful of top European Union posts that are expected to be negotiated by EU leaders as a package over the coming months,” reports the Wall Street Journal.[17] Those posts include the ECB vice president, the head of the “Eurogroup” committee of eurozone finance ministers, and head of the ECB’s banking supervisor, the European Banking Regulator.

While Draghi doesn’t leave his seat until November 1, 2019, the negotiations between EU member states will heat up next year with a resolution likely by year-end 2018. The ECB president is nominally selected by a qualified majority vote of the European Council, but it’s really a majority of the subgroup that uses the euro. In addition to Weidmann, there is Francois Villeroy de Galhau of the Bank of France. But France already had the seat with Draghi’s predecessor, Jean-Claude Trichet. Given that, insiders say Weidmann has the lead because there are no Germans currently heading the EU institutions. His hard money stance, though, is a negative for some EU member states. And some think that gaining the ECB presidency means Germany would forfeit a shot at either the Presidency of the European Commission, now held by Jean-Claude Juncker, the former Prime Minister of Luxembourg, or the Presidency of the European Council, currently held by Donald Tusk, former Prime Minister of Poland. Both their terms expire at the end of 2019.

CHART: POSITIONS HELD ON ECB EXECUTIVE BOARD
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SOURCE: “Merkel will push for Weidmann as Draghi Successor Spiegel Says.” Bloomberg, May 19, 2017. https://www.bloomberg.com/news/articles/2017-05-19/merkel-will-push-for-weidmann-as-draghi-successor-spiegel-says .


James Spellman is an independent Financial Consultant with Strategic Communications LLC.


[1]European Central Bank, “Asset Purchase Programmes.” https://www.ecb.europa.eu/mopo/implement/omt/html/index.en.html . "When the ECB buys bonds in the primary market it is essentially taking the place of some other investor who would have bought the bonds but cannot because the ECB bought them instead. That other investor still has money that it wants to invest but no more Apple or MacDonald's (as an example) bonds to buy. So they have to use that money for some other investment. That is how the ECB pushes liquidity into the economy," Erik Jones, professor of International Political Economy at Johns Hopkins University, told CNBC via email. Silvia Amaro, “This is why the ECB purchases corporate bonds. CNBC, June 26, 2017. https://www.cnbc.com/2017/06/26/this-is-why-the-ecb-purchases-corporate-bonds.html . The original decision was taken on September 6, 2014. Ian Traynor, “ECB introduces unlimited bond-buying in boldest attempt yet to end euro crisis.” The Guardian (U.K.), September 6, 2014. https://www.theguardian.com/business/2012/sep/06/debt-crisis-mario-draghi .
[2]Henrik Böhme, “Opinion: Draghi's feeble trend reversal.” Deutsche Welle, October 26, 2017.
http://www.dw.com/en/opinion-draghis-feeble-trend-reversal/a-41127210 .
[3]Tom Fairless, “ECB Decision Reopens Divide Atop Central Bank.” Wall Street Journal, October 27, 2017.
https://www.wsj.com/articles/ecb-decision-reopens-divide-atop-central-bank-1509119783 . See speech by Jens Weidmann in Paris, October 27, 2017. “Die Zukunft der Währungsunion sichern.” “Ensuring the future of the monetary union.” https://www.bundesbank.de/Redaktion/DE/Reden/2017/2017_10_27_weidmann.html .
[4]Will Martin, “The ECB announced 'a sea change but a very gentle one.' “ Business Insider, October 26, 2017.
http://www.businessinsider.com/european-central-bank-october-monetary-policy-decisions-2017-10?r=UK&IR=T .
[5]Interview.
[6]Deutsche Bank.
[7]Lorenzo Bini Smaghi, “The ECB’s self-imposed limits complicate its QE exit.” Financial Times, October 12, 2017. www.ft.com .
[8]Elaine Moore, “When will the ECB run out of bonds to buy?” Financial Times, September 8, 2016. www.ft.com
[9]ECB, “Implementation aspects of the public sector purchase programme (PSPP).” Updated January 2017.
https://www.ecb.europa.eu/mopo/implement/omt/html/pspp.en.html .
[10]Balazs Koranyi and Francesco Canepa, “Baby step but no big bang: ECB warily starts pulling back from loose money.” Reuters, October 25, 2017. www.reuters.com/article/us-ecb-policy/baby-step-but-no-big-bang-ecb-warily-starts-pulling-back-from-loose-money-idUSKBN1CU367 .
[11]Hans Dewachter, Leonardo Iania, and Jean C. Wijnandts, “The Response of Euro Area Sovereign Spreads to the ECB Unconventional Monetary Policies.” October 14, 2016. National Bank of Belgium Working Paper No. 309 - October 2016. https://ssrn.com/abstract=3038685 . “…[W]e show that the ECB’s announcements reduced both the average expected instantaneous spread and risk repricing components of Italian and Spanish spreads. For countries such as Belgium and France, the ECB announcements impacted primarily the risk repricing component of the spread.”
[12]Arvind Krishnamurthy, Stefan Nagel, and Annette Vissing-Jorgensen, “ECB Policies Involving Government Bond Purchases: Impacts and Channels.” October 2017. CEPR Discussion Paper No. DP12399. https://ssrn.com/abstract=3061832 . “On average across Italy, Spain and Portugal, considering both the Securities Markets Programme and the Outright Monetary Transactions, yields fall considerably. Decomposing this fall, default risk accounts for 37% of the reduction in yields, reduced redenomination risk for 13%, and reduced market segmentation effects for 50%. Stock price increases in distressed and core countries suggest that these policies also had beneficial macro-spillovers.”
[13]Jack Ewing, “As European Central Bank Eases Emergency Measures, Risks May Lurk.” New York Times, October 25, 2017. https://www.nytimes.com/2017/10/25/business/european-central-bank-tapering-draghi.html?_r=0 .
https://www.nytimes.com/reuters/2017/10/19/business/19reuters-ecb-policy-poll.html?_r=0 .
Also: The International Monetary Fund revised its growth forecast for the currency block in 2018 from 1.9 percent, forecast in July, to 2.1 percent, forecast in October.
[14]Paul Hannon, “Eurozone factory output surges in August.” Wall Street Journal, October 12, 2017.
http://www.marketwatch.com/story/eurozone-factory-output-surges-in-august-2017-10-12 .
[15]Paul Hannon, “Eurozone Consumer Confidence at 16-Year High.” Wall Street Journal, October 23, 2017.
https://www.wsj.com/articles/eurozone-consumer-confidence-at-16-year-high-1508769368 .
[16]“Merkel will push for Weidmann as Draghi Successor Spiegel Says.” Bloomberg, May 19, 2017. https://www.bloomberg.com/news/articles/2017-05-19/merkel-will-push-for-weidmann-as-draghi-successor-spiegel-says .
[17]Fairless, op. cit.