Louis Harreau of Credit Agricole CIB may have cracked the code for how the European Central Bank will end its quantitative easing program.
It’s contained in a simple equation, which he has dubbed the “new generation” Taylor rule, a reference to a tried-and-tested central bank model for setting interest rates based on how much inflation and growth are deviating from their target rates.
His formula goes like this:
Monthly net injection from the ECB in billions of euros (QE +TLTROs) = 120 x (1.5 - core inflation).
How does it work? Harreau observed that before price pressure began to falter in the euro area around 2013, the core inflation would average 1.5 percent a month. So at that level, conventional monetary policy should be enough, he reasons. Harreau then looked closer at three episodes of the ECB’s massive easing program:
- From March 2015 to March 2016, when the ECB began buying assets at a rate of 60 billion euros ($69 billion) per month and carried out a series of targeted long-term refinancing operations, essentially offering cheap three-year loans to euro-area banks.
- From April 2016 to March 2017, when the monthly purchases jumped to 80 billion euros and more funds were loaned to banks, while some of the previous ones were paid off.
- And finally, the current period that runs until the end of this year, when the Governing Council pledged to continue its QE at an average monthly pace of 60 billion euros.
Harreau crunched the numbers and came up with an “A factor” that solves the equation for these three periods: the number 120.
After plugging in his forecast for core inflation, the formula suggests the ECB will reduce its monthly pace of asset purchases to 35-40 billion euros at the beginning of next year, then to 20 billion from July and wrap up the program at the end of 2018.
A classic disclosure obviously applies: past performance is no guarantee of future results. Harreau’s forecast may turn out to be wrong. But he could be on to something.
The euro-area recovery is clearly gathering pace and some policy makers have signaled the decision on how to end the bond buying is getting near. Draghi said in in a speech in Sintra last month that “the central bank can accompany the recovery by adjusting the parameters of its policy instruments – not in order to tighten the policy stance, but to keep it broadly unchanged.”
How that will come about is for Draghi and his colleagues to decide. Their next decision is already this Thursday.