The ECB Shows It Has Won the Market's Trust
The European Central Bank's decision to reduce the pace of quantitative easing as of next year is the story of the dog that didn't bark. For months, the expectation was that this historic announcement would cause disruption in the financial markets, sending bond yields higher and stock prices lower. What we saw instead was a very orderly and even cheerful reaction -- showing central banks may have finally mastered how to communicate with investors.
The ECB's announcement was hardly trivial. When President Mario Draghi announced nearly three years ago that the central bank would purchase 60 billion euros ($70.16 billion) of bonds each month to fight off the threat of deflation, this was seen as a major change in the conduct of monetary policy. Unlike the U.S. Federal Reserve, the ECB had been reluctant to engage in quantitative easing. The fear, coming from Germany and other countries, was that it would amount to a financing of government deficits, which is prohibited by the European treaties. The move has undoubtedly been successful: Growth has returned to the euro zone, and the risk of deflation has disappeared.
The question, however, has always been how financial markets would react to the first sign of removal of this monetary shield. In the U.S., the Fed found it difficult to communicate its exit from QE -- as shown by the "taper tantrum" in June 2013, which caused shockwaves in the U.S. Treasury market and across the emerging world. The ECB had its own mini-tantrum this June, after a speech by Draghi at a conference in Sintra, Portugal, caused euro zone bonds to rise -- before falling again through the summer.
The market reaction yesterday, however, was more of a collective shrug. The euro slid by more than a percentage point on the day. Bond yields across the currency union also fell. Meanwhile European stock markets continued to advance as they also celebrated signs that the crisis in Catalonia may be defused.
The ECB's decision is only a first step in a long process of normalization. It will continue to purchase 30 billion euros in government and corporate bonds each month from January until September. Policy makers chose to leave the asset-purchase program open-ended and even reserved the right to increase its size if economic conditions worsened. Draghi confirmed that interest rates will remain low well past the horizon of QE.
However, the relative calm in the financial markets has three further explanations.
First, the ECB appears to be getting its timing broadly right in beginning to withdraw its support. The euro-zone recovery has broadened to nearly all member states, including weaker economies such as Portugal and Italy. Investors are showing a renewed willingness to invest in these countries, helping the central bank to take a small step back.
Second, the central bank has also been good with its communications. Draghi was quick to note as much in his press conference: "My understanding is that market reaction was pretty muted," he noted, "in spite of the fact that it's a policy announcement of a certain importance." Market participants broadly expected both the size of the reduction and the length of the extension; it was precisely in line with the expectation of most of economists surveyed by Bloomberg ahead of the decision.
Finally, the reaction shows that the existential threat to the euro zone seems to have disappeared for now. Investors know that even if the ECB were to walk away from markets one day, it can always come back if needed. Draghi was careful to leave open the option of reversing course. This is a major difference compared to the sovereign debt crisis -- when the lack of a central bank backstop contributed to the ballooning of sovereign bond yields in weaker countries -- and one which will help to keep the euro zone more stable.
There are plenty of risks ahead for the ECB. Divisions on the governing council, which began to appear this week, may deepen. Inflation may pick up more quickly than expected, forcing the central bank to renege on its earlier commitments. Investors may change their minds -- for example, if the next rate hike by the Fed prompted bond yields to rise worldwide. But for now, the ECB seems to have got its message and its policy just right.
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Therese Raphael at firstname.lastname@example.org