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ECB normalisation: the journey is more important than the destination
  • The strength of the eurozone’s recovery in 2017 prompted the European Central Bank (ECB) to adjust its bond-buying programme. However, the bank’s overall policy stance has remained accommodative. As the region’s expansion continues, a review of monetary policy tools within the bank’s current framework will be needed to allow for additional steps towards policy normalisation.
  • Policy support has been effective. Quantitative easing (QE) has compressed sovereign bond yields by 70bps to 160bps since it began in 2015, according to our analysis. The ECB estimates that the policy measures taken between mid-2014 and October 2017 will boost growth and inflation by about 1.9 percentage points, in both cases, for the period between 2016 and 2020. However, cost-benefit considerations suggest that it is now appropriate to start preparing for an exit from QE.
  • The evolution of the ECB’s monetary policy stance will largely depend on a sustained adjustment in inflation in the medium term towards the ECB’s target. The outlook for inflation is clouded by uncertainties and risks. In particular, escalating US-China trade tensions and further euro appreciation could blur this outlook.
  • The path towards eurozone monetary policy normalisation will be gradual, cautious and predictable. The ECB will likely replicate the steps taken by other major central banks at more advanced stages of the normalisation cycle over the next few years. But, over that horizon, any economic weaknesses could result in some aspects of the ECB’s plan being shelved – before they can be implemented.
  • In recent years, the ECB has done much of the heavy lifting in terms of providing crisis-era stimulus and averting the break-up of the single-currency bloc. More European integration is needed to deal with the next crisis better, when it hits. But that process is likely to be gradual, with only modest progress in the offing.

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:

  1. 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.
  2. 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.
  3. 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 1.

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%2.

Accordingly, they have stipulated that a sustained adjustment must encompass three features:

  1. Convergence: the ECB’s forecasts need to show inflation heading towards the 2% target in the policy-relevant medium term;
  2. Confidence: the ECB must be sure that there is a sufficiently high probability that the adjustment will materialise; and
  3. 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 outlook3. 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)4.

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 outlook5.

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:

“Adjustments to our policy will remain predictable, and they will proceed at a measured pace that is most appropriate for inflation convergence to consolidate, taking into account continued uncertainty about the size of the output gap and the responsiveness of wages to slack.6"

The pre-set sequencing of the ECB’s exit from QE contributes to the predictability of the process. ECB officials have suggested that in the foreseeable future normalisation efforts will evolve largely in-line with those of other major central banks (most notably, the Federal Reserve) that are at more advanced stages of the normalisation process. In broad terms, that means the end of net QE purchases will mark the first step in the normalisation process, followed by a rate hike, and a gradual and passive balance sheet adjustment (by reducing the pace of reinvesting maturing securities) will conclude the process, once a buffer for rates has been rebuilt.

However, some details on the exit from QE remain unknown. For example, it is not yet clear how forward guidance on rates (currently linked to net QE purchases) will evolve in the future. Indeed, as the end of QE draws closer, the current monetary policy framework – QE, the reinvestment policy and forward guidance on rates – will need to 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. Indeed, a limited extension of QE would mark a more persistent presence of the ECB in the market. In addition, it would strengthen the forward guidance on rates. The announcement of a QE extension is likely to take place in July.
  • An emphasis on the existing ECB holdings: As the end of net QE purchases approaches, the existing link between QE and the inflation outlook7 will probably evolve into a link between the overall set of policies in place (i.e. low interest rates, a large stock of holdings, and the reinvestment policy) and the inflation outlook.. There will be more emphasis on the stock of holdings. 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. In addition, the reinvestment policy implies that the ECB will maintain a presence in the market: reinvestments are estimated to amount to €167bn in 2019 and they will remain sizeable thereafter.
  • The evolution of 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.

The normalisation process will take a few years. And what’s more, adverse changes in circumstances may derail it over that horizon. This observation is quite relevant, particularly at a time of escalating trade tensions and increased market volatility. In addition, the eurozone would not be immune to a US slowdown, which could possibly be triggered by some sort of policy error in the context of a mature business cycle.

It is also worth noting that the normalisation process will still be ongoing when Draghi’s term as ECB President ends in October 2019. The base case is that, by that time, a framework for normalisation will be in place and Draghi’s successor will have to abide by it. Nevertheless, there is a possibility that a more hawkish President could push for swifter normalisation efforts. Early political moves (most notably the appointment of Spain’s Finance Minister Luis De Guindos as the ECB’s Vice President) suggest that Bundesbank President Jens Weidmann is the frontrunner. However, general conditions and political equilibria might change between now and mid-2019. Indeed, while it looks like a German ECB presidency is now overdue, the last succession process in 2011 showed that fortunes can change at the last minute.

The ECB is the only game in town – more European integration is 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 (most notably, at the height of the European sovereign debt crisis). 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 it is clear that the eurozone needs more integration to better respond to the next crisis, when it happens. In this respect, the current European political scene presents opportunities and challenges. Encouragingly, it now 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 remains unclear whether European governments have the much-needed political capital for reform – and if they are willing to spend it.

In June, European leaders will convene at the European Council meeting, where they are expected to agree on a roadmap for EU reform. At this stage, critical advancements in the integration process are unlikely. Yet, a consensus on some points might emerge, such as the completion of the Banking Union, the strengthening of the European Stability Mechanism (with new supervision, crisis-management and investment tasks), and a modest increase of the eurozone’s spending capacity8. Importantly, the timeline for such developments will probably be diluted into the future.

A bumpy road ahead?

In conclusion, the ECB faces a myriad of challenges on its path to monetary policy normalisation. The most pressing ones are technical, concerning the calibration of the appropriate monetary policy setting in light of uncertain inflationary dynamics, financial markets’ potential reactions, and cost-benefit considerations on unconventional policies.

At the same time, the political backdrop might interfere in the normalisation process, not just because the top ECB position is up for grabs but, more importantly, because a slow EU integration process will place a heavier burden of responsibilities on the ECB.

For now, however, we can best conclude that Draghi's “patient, persistent and prudent” approach seems to be the right mantra to follow.

  1. 1“Assessment of quantitative easing and challenges of policy normalisation” by Peter Praet, published by the European Central Bank on 14 March 2018
  2. 2See, for instance, “Monetary Policy in the Euro Area”, by Mario Draghi, published by the European Central Bank on 14 March 2018
  3. 3“Monetary Policy in the Euro Area”, by Mario Draghi, published by the European Central Bank on 14 March 2018
  4. 4“Introductory statement to the press conference (with Q&A)”, published by the ECB on 6 March 2014
  5. 5“Monetary Policy in the Euro Area”, by Mario Draghi, published by the European Central Bank on 14 March 2018
  6. 6“Monetary Policy in the Euro Area”, by Mario Draghi, published by the European Central Bank on 14 March 2018
  7. 7The 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.”
  8. 8See, for instance, “The sustainability of European Monetary Union and institutional reform”, speech by Francois Villeroy de Galhau, 14th March 2018

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