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ECB Learns Fed Lesson on Reducing Monetary Dose

Mark Gilbert is a Bloomberg View columnist and writes editorials on economics, finance and politics. He was London bureau chief for Bloomberg News and is the author of “Complicit: How Greed and Collusion Made the Credit Crisis Unstoppable.”
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Last week, ECB chief Mario Draghi promised another nine months of quantitative easing, but cut his bond purchase program. While the move is a deft way to introduce the prospect of tapering without triggering a market meltdown, the economic backdrop suggests it's still too soon for tighter monetary conditions.

By reducing the dose while extending the prescription, the ECB was appeasing both the hawks and doves on its governing council. Draghi can still say he's doing whatever it takes to bolster the economy. And he can avoid rattling the markets as the Fed did when it first flirted with unwinding QE. But a look at the Federal Reserve's timing with its own tapering program suggests the ECB may be withdrawing its financial support too soon.

In June 2013, the Fed gave the first hint that its experiment with unprecedented monetary stimulus was nearing an end. The then-Chairman Ben Bernanke told the world that an improving economy might make it "appropriate to moderate the monthly pace of purchases later this year."

QuickTake Reducing QE

The bond market swooned into what became known as a taper tantrum. Within a week, the 10-year U.S. Treasury yield had climbed 40 basis points to 2.6 percent; less than three months later it touched 3 percent.

The reaction has arguably inhibited Fed policy ever since. When the central bank first raised interest rates a year ago, it was supposed to presage four more increases this year. Instead, this week's tightening was only the second. So it's a smart move by the ECB to present a taper-that-isn't-quite-a-taper, implementing a reduction while insisting the economic patient is still tethered to its life support machinery. The German 10-year bond yield, which has been ticking higher since the low of -0.2 percent in July, has barely budget since last week's ECB announcement, bobbling along just shy of 0.4 percent.

But it's only smart if the recovery in the euro zone economy is sufficiently embedded for the ECB to make further cuts in its stimulus efforts. That's not so clear.

Compare how loans to households and companies, a proxy for investment and consumption appetite, has developed in the euro region this decade, and how strong it was before the Fed contemplated its taper:

Is the ECB Tapering Too Soon?
Year on year change in outstanding loans to households and companies
 
Source: Dan Hanson, Bloomberg Intelligence

While euro loan demand has stopped falling, the stock of loans increased by an anemic 1.1 percent in the third quarter, a far cry from the 3.8 percent the U.S. was enjoying when the Fed broached the topic of a QE reduction.

Moreover, the inflation outlook for the two economic regions also suggest the ECB may be premature in starting to backtrack. Five-year forward inflation break-even rates, a favored measure of market inflation expectations among central bankers, were above the Fed's 2 percent target for consumer price gains in mid-2013. In the euro zone, the gauge has been steadily increasing this year, but is still stuck below 1.7 percent and adrift of the ECB target:

Inflation Outlooks
Five-year forward inflation breakeven rates
 
Source: Bloomberg

It took the Fed six months to make good on its warning to curb QE. It began to scale back its buying in December 2013, finally ending the program in October 2014. It took a further two years for it to raise interest rates. Given the limited recovery seen so far in European economies, the ECB would do well to be cautious in 2017 if it makes any further attempts to remove the QE pacifier. 

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

To contact the author of this story:
Mark Gilbert at magilbert@bloomberg.net

To contact the editor responsible for this story:
Therese Raphael at traphael4@bloomberg.net