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The factors guiding the ECB’s uncertain path to monetary normalisation

Despite the eurozone’s economic recovery, the European Central Bank’s (ECB) overall policy stance has remained accommodative.  However, as economic expansion continues, a review of monetary policy tools within the bank’s current framework is required argues Silvia Dall’Angelo, Senior Economist at Hermes Investment Management. In her latest Ahead of the Curve, she assesses the factors influencing the uncertain path to monetary normalisation and discusses how policy may be reshaped.

QE & the law of diminishing returns
Our analysis suggests QE has had a significant impact on sovereign bond yields, with a reduction of between 70bps to 160bps across jurisdictions. The ECB has reached similar conclusions, indicating unconventional monetary policy measures have compressed long-term yields by about 100bps. In addition, the bank estimates that monetary policy measures introduced between mid-2014 and October 2017 will boost growth and inflation by about 1.9 percentage points between 2016 and 2020.¹

While the bond-buying programme has been effective, cost-benefit considerations suggest it is now an appropriate time to prepare for an exit from QE. Today, the marginal benefit of QE is modest, while its costs, in terms of distortions in financial markets and distributional effects, are high.

Converging views on inflation
Despite the acceleration in economic activity, inflation has not followed through – running well below the ECB’s target of slightly below 2%. ECB President Mario Draghi has made it clear there is “a very clear condition” for ending bond buying: a sustained adjustment in the path of inflation towards the goal of just under 2%2 that encompasses three features: convergence, confidence and resilience

Progress has been made on convergence and confidence, but the inflation trajectory still relies significantly on monetary policy support. The ECB’s inflation forecasts have consistently shown a gradual convergence towards the 2% target and adjustments between successive forecasting rounds have been more contained recently (see chart  below). Moreover, the strength of the economic recovery has underlined policymakers’ increasing confidence.

The ECB’s inflation forecasts have shown a gradual convergence towards the 2% target

Source: Hermes, based on data from European Central Bank and Eurostat, Hermes as at April 2018

Draghi has suggested two factors that might explain why inflation has surprised to the downside: Firstly, the responsiveness of the price formation process to slack has weakened (i.e. a flatter Phillips curve). Secondly, underemployment measures point to more slack in the labour market than suggested by the unemployment rate.

 Downside surprise warnings
Draghi also warned of two external downside risks to the inflation outlook. An escalation of trade tensions would act as a supply shock for the economy and likely give way to a period of stagflation. Cost-push pressures would temporarily drive inflation higher, while weaker demand would probably result in softer inflation in the future. Moreover, higher barriers to international trade would particularly damage the open eurozone economy.

Meanwhile, further euro appreciation and tighter financial conditions also have the potential to depress already subdued inflation dynamics. According to Draghi, as a rule of thumb, a 10% appreciation in the permanent effective exchange rate lowers inflation by about 40bps to 50bps3.

Reshaping monetary policy
The ECB’s approach to normalisation will be gradual and cautious in the foreseeable future. The end of net QE purchases will mark the first step in the process, followed by a rate hike, and a gradual and passive balance sheet adjustment. However, some details on the exit from QE remain unknown. As QE draws to a close, the current monetary policy framework – QE, the reinvestment policy and forward guidance on rates – must be reshaped before further steps are taken towards policy normalisation.

This may include an extension of QE until the end of this year and a subsequent end to net purchases. We expect that tapering will continue over the fourth quarter, with a monthly purchasing pace of between €10bn and €15bn.  The impact from this limited extension would be marginal; it would be much more about its signalling effects.  In addition, it would strengthen the forward guidance on rates. The announcement of a QE extension is likely to take place in July.

We may also see an emphasis on the existing ECB holdings. As the end of net QE purchases approaches, the existing link between QE and the inflation outlook4 will probably evolve into a link between the overall set of policies in place and the inflation outlook. Accordingly, the bank’s policy of reinvestment of maturing bonds will assume more relevance when QE ends, as it will allow it to maintain a large balance sheet.

Evolving forward guidance
The current forward guidance states that policy rates will remain at their current levels “well past” the end of the QE programme. This probably means by about six months. As such, if QE is extended until the end of the year, the first small rate hike (of no more than 25bps) will probably take place in mid-2019.

Before the end of QE, forward guidance will need to evolve to ensure a gradual and predictable normalisation path for policy rates. There will probably be heightened emphasis on data-dependency, notably with respect to indicators concerning domestically-generated inflationary pressures.

More integration needed
In recent years, the ECB has done much of the heavy lifting, providing a response to crises and ensuring the survival of the single currency when its feasibility was questioned. At times, the ECB has over-stretched as it attempted to make up for the shortcomings of the European institutional framework.

However, there are limits to the reach of monetary policy and the eurozone needs more integration to better respond to the next crisis. Encouragingly, it looks like the French and German governments are aligned in recognising the need for EU reform. However, in the context of growing populist pressures, it is unclear whether European governments have the much-needed political capital for reform – and if they are willing to spend it.

ECB faces a myriad of challenges on its path to monetary policy normalisation. The most pressing concern the calibration of monetary policy in light of uncertain inflationary dynamics, potential market reaction, and cost-benefit considerations of unconventional policies.

Meanwhile, politics might interfere in the normalisation process, as a sluggish EU integration process will place a heavier burden of responsibilities on the ECB.  Against this backdrop, Draghi's “patient, persistent and prudent” approach seems to be the right mantra to follow.

1 “Assessment of quantitative easing and challenges of policy normalisation” by Peter Praet, published by the European Central Bank on 14 March 2018

2 See, for instance, “Monetary Policy in the Euro Area”, by Mario Draghi, published by the European Central Bank on 14 March 2018

3 “Introductory statement to the press conference (with Q&A)”, published by the ECB on 6 March 2014

4 The link between QE and the inflation outlook is currently formulated as follows: “we intend to continue to make net asset purchases (…) until the end of September 2018, or beyond, if necessary, and in any case until the Governing Council sees a sustained adjustment in the path of inflation consistent with its inflation aim.”

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