What to Expect From the ECB Meeting
In what many regard as its most important policy meeting of the year, the European Central Bank is set to announce Thursday its plans for balance-sheet management in 2018. Policy makers hope to emulate the Federal Reserve in setting out a plan that not only strikes the right balance for the economy, but does so without disrupting financial markets. The challenge is that the euro zone’s overall economic and financial conditions are notably more complicated than those of the U.S. And this matters beyond Europe, given the scope for German yields, in particular, to influence those on other government bonds, including Treasuries, as well as currency markets and overall financial stability.
The most likely outcome from the ECB’s Governing Council deliberations is specific guidance to the markets on a very gradual reduction in monthly asset purchases, combined with two-way optionality to accommodate the prospects for both fluid and uncertain economic and financial conditions. In the first instance, this could involve cutting by around half the current pace of monthly purchases of 60 billion euros ($71 billion), together with more signals that successful implementation and follow-up balance-sheet tweaks would need to come before any move up in what are still negative policy interest rates.
In announcing that guidance, the ECB hopes to follow the Fed in embarking on the path of a “beautiful normalization” of policies after an unexpectedly-long period of reliance on unconventional measures. At a minimum, this requires the bank to strike a delicate balance between a measured exit and the retention of policy flexibility. And that balance may be inherently harder to strike for the euro zone.
Three key elements are helping the ECB as it faces headwinds from elsewhere: a notable reduction in the threat of deflation, a regionwide pickup in growth indicators, and increased recognition of the risks of collateral damage and unintended consequences associated with prolonged reliance on unconventional policies.
Against that, and particularly when compared to the U.S., the euro zone is less advanced in its economic recovery, both from a cyclical perspective and in terms of developing structural roots for long-term inclusive growth. The appreciation of the euro over the last few months adds to the growth and lowflation challenges, as does the ECB’s need to deliver a policy mix that makes sense for the vast majority of its economically and financially diverse 19 member countries.
The political context is also more complex. The ECB has been under pressure from its northern European members, including Germany, to remove stimulus and step back from what they view as a highly distortionary market influence. Its southern members, however, favor prolonged stimulus to assist a recovery that has only recently started building serious momentum. These competing views are said to play out behind closed doors in the Governing Council deliberations.
The stakes for a beautiful ECB normalization are not limited to the central bank’s membership. They extend well beyond the euro zone, given the potential impact on global yields and the stability of foreign exchange markets.
It is also far from clear the extent to which the global economy and markets as a whole can navigate not one, but two simultaneous policy normalizations by systemically important central banks -- let alone the possibility the Bank of Japan and the People’s Bank of China could follow the same path.
Judging the full impact of Thursday’s ECB meeting will require time. Success will prove a function of more than the policy content itself and the bank’s openness to course corrections if needed. It will also depend on what other euro-zone policy makers do. This is particularly the case with pro-growth structural reforms and the fiscal stance, as well as how the overall policy matrix impacts a global economy that is still searching for a stronger growth model and seeking to lower the financial stability risks associated with elevated asset prices that, powered by ample central bank and corporate liquidity, have decoupled from underlying fundamentals.
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