The Politics of Ending Europe's Stimulus
Did you notice that when the European Central Bank responded at its June meeting to the euro zone’s increasingly strong economic recovery by announcing it would not cut record low interest rates any further, the euro went down instead of up?
Markets, apparently convinced by the ECB’s pledge to stick to its present forward guidance that interest rates won’t be going up for a long time, did not bid up the euro when the first baby steps toward a rate increase actually were taken. That speaks volumes to the credibility of the ECB’s forward guidance message in markets.
That’s a good thing too, because the central bank is going to need all the credibility it can muster as the September national elections in Germany draw near. The ECB, and its president Mario Draghi, can not afford to lose the good will of German Chancellor Angela Merkel who has made it perfectly clear she wants an interest rate increase for German savers around election time, a demand that is in direct conflict with the bank’s forward guidance. For the ECB not to deliver is to lose favor with Europe’s most powerful politician.
Of course, Mrs. Merkel can’t fire Draghi, whose term is not renewable. But she can help make him into a lame duck for the final two years of his time in office. The chancellor’s tacit support for Draghi’s policies has encouraged some governing council members to vote Draghi’s way. She can also encourage the debate on Draghi’s successor to continue, which would be the classic way for undermining the authority of the present office holder.
The ECB’s official mandate is, of course, to target the inflation rate. But because there is no political union in the EU (or fiscal union) it has always been clear that the central bank pays considerable attention to the political backdrop, one reason it was careful not do anything that might rock the boat during the French presidential campaign.
Besides, while negative interest rates made sense when the central bank was fighting deflation, they are inappropriate for the euro zone’s increasingly robust recovery, even if inflation remains below its 2 percent target. The sooner the ECB unwinds them the better.
Putting even more pressure on the ECB to increase interest rates in September is the likelihood that the central bank will have to postpone tapering its QE until after the Italian elections, which are now scheduled for next spring after Italian politicians flirted with a snap election this fall. An interest rate hike in the fall would give the ECB breathing space to put off tapering and extend QE when its current program expires at the end of the year.
The alternative would be too risky. Tapering first could provoke market turbulence that works to the advantage of the populist Five Star Movement in an election. For financial stability reasons, the ECB needs QE to be robust when Italians go to the polls, just as it needed the stimulus to continue in France, where delaying policy normalization paid handsome dividends in sowing defeat for the populists (or at least denying Marine Le Pen’s National Front any fodder for her anti-euro line).
Five Star, which has promised a referendum on the euro if it wins, is no less dangerous for Europe than the National Front was in France. We are talking about systemic risk here. Yes, extending QE past the end of this year probably necessitates the ECB loosening some of the rules for asset purchases it has imposed on itself. The central bank is said to be running out of German securities to buy for its asset purchase program, and it may have to buy more southern sovereign debt than northern central banks are comfortable with.
This is where Merkel’s support could prove very useful to the ECB. If the chancellor signals a willingness to bend the so-called capital key rules -- which ties the proportion of QE purchases the ECB can make of a member’s bonds to what that member contributes to the ECB’s capital -- to fight the Italian populists, Bundesbank President Jens Weidmann (a hawk on the ECB governing council) is not likely to oppose her, especially since she recently endorsed him to be the next ECB president.
Even ECB hardliners like Weidmann are likely to understand that strict adherence to the rules makes no sense when there is an existential risk for the euro. The ECB is likely to change rates before it will change course on QE.
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