ECB Meeting Comes at a Precarious Time for Markets

The recent economic data out of the euro zone is encouraging. Production, manufacturing and confidence are robust, and inflation has stabilized. That’s not to say that there aren’t risks to the downside, such as growing populism, global geopolitical tensions, and uncertainty about sustainability of the economic recovery. To insure against these risks, the European Central Bank, which has a monetary policy meeting Thursday, has the option of boosting asset purchases.

For that to happen, though, the economic outlook has to become less favorable and financial conditions would need to be inconsistent with achieving sustainable inflation. Then there is the issue of credibility. If the ECB were to increase purchases, it could signal the economic outlook is deteriorating. But if the ECB keeps the status quo, it risks seeing an unexpected shock tighten financial conditions too quickly. When political events such as elections in France and Germany impact the economy, the ECB may choose to hold off on any action until the effects are revealed, but by then it may be too late. Markets understand this credibility issue, and financial conditions have begun to tighten while real interest rates have risen. The last time this happened was in April 2010 right before the Greek debt crisis erupted.