Tentative steps towards ECB monetary policy normalisation
Last year, the ECB started to adjust its crisis-era stimulus programme, reflecting policymakers’ increased confidence in the eurozone economy, as the recovery evolved into a fully-fledged expansion. At the same time, the bank has also maintained its accommodative monetary stance.
The changes have been two-fold: QE tapering and, less importantly, the removal of easing biases. The tapering process is now well advanced: the monthly pace of purchases has been dialled down twice. In April 2017, the ECB reduced its monthly purchases from €80bn to €60bn. The pace halved to €30bn at the start of this year, with purchases scheduled to run until at least September. Meanwhile, the ECB dropped its pledge to increase quantitative easing if the eurozone expansion sputters – the so-called “easing bias” on QE described at its March meeting. It had previously dropped the easing bias on rates in June 2017.
Importantly, the main pillars supporting the ECB’s expansionary stance are still in place:
- The Asset Purchase Programme (APP), known as QE, is set to continue at a monthly pace of €30bn until September this year, or later, if needed.
- The reinvestment policy will remain in place indefinitely, allowing the ECB to hold a large stock of securities, even after its bond-buying programme ends.
- The forward guidance stipulates that rates will remain at their current levels “well past” the end of the ECB’s bond-buying programme.
As the expansion continues, thereby strengthening confidence in the inflation outlook, a review of monetary policy tools used in the current framework will be needed to allow for further steps towards policy normalisation. Although future monetary policy adjustments are not yet clear, there is one certainty: the continued weakness of inflation – which is likely to converge with the central bank's target of 2% slowly – means that the approach to normalisation will be gradual and cautious.
The emergence of new risks, however, complicates the picture. Trade tensions and increased volatility in financial markets are now muddying the outlook. In addition, the eurozone would not be immune to a slowdown in the US, where the business cycle is at a later stage and the vulnerability to policy errors is higher. For this reason, the ECB’s plan for the final stages of monetary policy normalisation might be shelved before they have a chance to come to fruition. As such, the process might be more about the journey than the actual destination.
Policy support has been effective, but cost-benefit considerations now point to the exit
Before we discuss the enabling conditions and possible path towards normalisation, we will update our assessment of the impact from the ECB’s QE programme thus far.
According to our analysis, QE has been effective in compressing sovereign bond yields across the board, resulting in easier credit conditions for businesses and households.
Since its introduction in early 2015, the ECB’s APP programme now amounts to almost €2.4tn (21% of GDP) and it is expected to hit €2.6tn (22% of GDP) by the end of the year – that’s assuming a modest extension of QE in the fourth quarter. Our analysis suggests that so far QE has had a significant impact on sovereign bond yields, reducing them by between 70bps to 160bps across different jurisdictions (see chart 1). Moreover, we found that QE had the biggest impact on larger countries, notably Germany, Italy and Spain. Indeed, while the capital key rule – implying the ECB is buying bonds roughly according to each country’s GDP share – has favoured larger purchases of German bonds, peripheral yields have shown a greater sensitivity to QE.
Chart 1: QE has compressed sovereign bond yields significantly
Source: Hermes’ estimates, based on Bloomberg, European Central Bank, and Eurostat data as at April 2018
The ECB has reached similar conclusions on the impact of QE. It found that 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 .
While the bond-buying programme has been effective, cost-benefit considerations suggest that it is now an appropriate time to prepare for an exit from QE. The eurozone economy is growing at its fastest pace since before the global financial crisis. Last year, eurozone GDP grew by 2.3% – well above its potential – and robust fundamentals suggest that the economy might enjoy a similar rate of growth in 2018. Today, the marginal benefit of QE is modest, while its costs, in terms of distortions in financial markets and distributional effects, are high.
The inflation goalpost
Despite the acceleration in economic activity, inflation – which still defines the ECB’s sole mandate – has not followed through. It is still running well below the ECB’s target of slightly below but close to 2%.
ECB President Mario Draghi and other bank officials have made it clear that there is “a very clear condition” for ending bond buying: there must be a sustained adjustment in the path of inflation towards the goal of just under 2%.
Accordingly, they have stipulated that a sustained adjustment must encompass three features:
- Convergence: the ECB’s forecasts need to show inflation heading towards the 2% target in the policy-relevant medium term;
- Confidence: the ECB must be sure that there is a sufficiently high probability that the adjustment will materialise; and
- Resilience: convergence to the 2% target needs to be self-sustained – that is, it should not heavily rely on monetary policy support.
Progress has been made on convergence and confidence, but the current rate of inflation has a low level of resilience. The ECB’s inflation forecasts have consistently shown a gradual convergence towards the 2% target in recent vintages and adjustments between successive forecasting rounds have been more contained recently (see chart 2). Moreover, the strength of the economic recovery over the last year has underlined policymakers’ increasing confidence in that view. However, the sustained upward trend towards the ECB’s target still largely relies on monetary policy support.
Chart 2: 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
During a recent speech in Frankfurt, Draghi provided colour on the uncertainties and risks concerning the inflation outlook. The ECB President suggested that two factors might explain why inflation has surprised to the downside:
- The responsiveness of the price formation process to slack has weakened in recent years (i.e. a flatter Phillips curve), which could be more persistent given past experiences (see chart 3);
- Economic slack in the region is still uncertain (see chart 4): underemployment measures point to more slack in the labour market than what is suggested by the unemployment rate alone. In addition, an uptick in demand might have stimulated the supply side of the economy, thereby creating more capacity. Past structural reforms (notably addressing the labour market) might also have raised the potential of the economy to grow.
Chart 3: The eurozone Phillips curve has flattened in recent decades
Source: Hermes, based on Eurostat data, as at April 2018
Chart 4: Measures of underemployment point to a considerable degree of labour-market slack
Source: Hermes, based on Eurostat data, as at April 2018
Other elements might influence wage dynamics and their pass-through effects on consumer prices. For example, it appears that an improvement in productivity has largely offset the recent pick-up in wages. In other words, it might be appropriate to monitor a set of economic indicators to gauge domestically generated inflationary pressures (see chart 5), including unit labour costs.
Chart 5: Indicators of domestically generated inflationary pressures remain subdued
Source: Eurostat as at April 2018
On top of endogenous uncertainties concerning the price-formation process, Draghi cautioned that two external sources of downside risks could jeopardise the inflation outlook – trade tensions and further euro appreciation.
An escalation of trade tensions, implying higher frictions to international trade, 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 eurozone economy, given its high degree of openness (see chart 6).
Chart 6: The eurozone still controls the largest share of international merchandise trade
Source: Hermes, based on World Bank data, as at April 2018
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 50bps (see chart 7).
However, the source of the appreciation also matters. Over the last year, euro appreciation (about 9% against a trade-weighted basket of 38 currencies) has probably had a limited impact on the eurozone inflation outlook, as it was mostly endogenous – that is, driven by better domestic economic conditions. By contrast, further euro appreciation from current levels would be mostly exogenous, reflecting, for instance, changes in trade policies abroad. This would have an adverse impact on inflation, in-line with the aforementioned rule of thumb.
Chart 7: Variations in the euro exchange rate impact eurozone inflation
Sources: Hermes, based on Eurostat and European Central Bank data, as at April 2018
A gradual path to normalisation
Draghi has used several speeches recently to reiterate that “monetary policy will remain patient, persistent and prudent” amid growing risks and uncertainty about the inflation outlook.
The ECB’s approach to normalisation will continue to be gradual and cautious in the foreseeable future. Its monetary policy stance will adapt to reflect evolving circumstances and changes will be clearly communicated to market participants and the general public. As Draghi stated: