Europe's Murky Path to Normal Monetary Policy
Much like a father holding the hand of his anxious son through a dark alleyway, the European Central Bank is striving to give markets guidance over how it will normalize its monetary policy.
The ECB has told investors that it intends quantitative easing to continue at a pace of 60 billion euros a month from April until the end of 2017. Interest rates will also remain low, it has said, "for an extended period of time" and, anyway, well after the end of the central bank's asset purchases.
Can you take all that to the bank? There are reasons to wonder.
With euro-zone inflation now running at 2 percent -- nominally above the central bank's target -- the ECB's "forward guidance" is coming under scrutiny. Investors are wondering whether rising price pressures will force it to taper QE earlier than expected. It could also change the sequence of its exit, raising rates before scaling down asset purchases.
The central bank is understandably reluctant to discuss all this in public. A senior official told me, "The day we start talking about it, this will send a signal to the markets and they will react." Privately, individual governors have already begun to form their own opinions.
A lot will depend on how they see the recent spike in inflation, which most economists attribute largely to the stabilization in energy prices.
The ECB sets out four conditions for judging whether this increase points to the need to tighten policy. Inflation has to move towards the ECB's target of just below 2 percent in the medium term; this convergence must look durable; it must apply to the whole of the euro zone; and it must be self-sustaining (that is, expected to persist even without monetary stimulus).
The current thinking is that these conditions aren't yet met. Underlying price pressures and wage growth remain subdued and there's no certainty that changes in the price of energy will have second-round effects on other components of inflation. The future trajectory of oil prices is anyway unclear. Unemployment in the euro zone can probably fall a bit further without putting pressure on wages -- an issue the ECB is studying.
Setting inflation aside, political uncertainty within and outside the euro zone argues for a steady hand. By the end of 2017, Germany and France -- the euro zone's two largest economies -- will have held elections, and central bankers will have a clearer idea of Donald Trump's policy intentions. And another reason to stand pat for now is credibility. In the absence of a major shock to inflation, tapering before the end of the year would be seen as a volte-face.
What about a different kind of tweak -- such as raising rates before tapering? Some of the governors may be open to this. Last week, Ewald Nowotny, head of Austria's central bank, said the council hadn't decided. Bear in mind that, unlike the Fed, the ECB has lowered the rate on reserves parked at the central bank to less than zero. A negative deposit rate squeezes banks' profit margins, which troubles some governors. However, for now, most seem to favor tapering first, followed by higher rates.
Another possibility would be to drop the reference to keeping rates low "well past the horizon of the net asset purchases," as the current guidance puts it. Some hawkish governors favor that idea. On Monday, they found an unlikely ally in Ignazio Visco, governor of the Bank of Italy and a long-standing dove, who told Bloomberg in an interview that the gap could be shortened.
The safest bet for now is to take the ECB at its word: QE is likely to run until the end of the year and rates to stay low until tapering is over. But when you're stumbling up a dark alley, forward guidance isn't as safe a hand as you might wish.
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