ECB Won’t Taper Quantitative Easing "Until Well into 2018"

Willem Verhagen, Senior Economist, Macro & Strategy at NN Investment Partners suggests the ECB are unlikely to deliver the kind of action on quantitative easing that those who are looking for a stronger Euro in 2017 are expecting.

The reaction function of the G3 central banks over the past few years can be summarised as a vastly underwhelming response to an improvement in the data.

The reason for this is that these central banks aim to enhance a positive feedback loop whereby the combination of rising nominal growth, low nominal rates and easy financial conditions leads to a further improvement in growth momentum.

Of course there are many shades of grey here.

The Federal Reserve is pretty close to its employment and inflation objectives, because of which it is gradually becoming more responsive to evidence of a continued robust growth momentum. By contrast, the responsiveness of the Bank of Japan (BoJ) is zero for now as it aims to fixate the 10y JGB yield at zero no matter what.

The European Central Bank (ECB) is somewhere in between but much closer to the BoJ since underlying inflation has remained well below target for years and shows no signs of accelerating.

Despite this, the clamour of certain pundits for an end to Quantitative Easing (QE) sooner rather than later is growing stronger as they feel their case is strengthened by accelerating growth, rising headline inflation and robust house price inflation in certain core country areas.

I could not disagree more and actually see a very strong economic rationale as to why the ECB should continue the current monetary policy stance, probably well into 2018.

Monetary policy is more about levels than it is about growth rates.

In the real economy, what matters is the difference between the actual output and its potential level.

The latter is not constant but can change over time due to structural reform but also as a function of the strength of overall demand. For instance, persistent demand strength can permanently push labour supply and productivity onto a higher growth path.

If this happens the rapid pace with which the EMU unemployment rate is currently declining will come down in much the same way as we have seen this happening in the US.

Eurozone Unemployment Still Too High

No one really knows where the equilibrium unemployment rate is.

Still, in early 2008 the unemployment rate fell to a low of 7.2% while core inflation remained below 2% (in fact core inflation has not been above 2% since early 2003!).

Of course, there may have been some unsustainable supply side expansion in the periphery (construction sector) before the crisis, because of which the equilibrium unemployment rate is now higher.

On the other hand, structural reform in various economies will have acted to push the equilibrium rate lower and this will certainly happen if France joins this pack.

All in all, I would not be surprised to see the unemployment rate fall well below 8% before triggering a significant acceleration in wage and price inflation.

This holds all the more so because there is ample evidence that inflation expectations have drifted towards levels below the inflation target. Market-based measures wax and wane with the global (commodity price) inflation tide but in level terms a clear gap has opened up with the US.

Meanwhile, survey based inflation expectations have become more sensitive to actual inflation outcomes, which suggests a sizeable risk that the well below target core inflation rate seen over the past few years will feed on itself going forward.

In this respect, wage inflation is an important underlying driver and virtually all indicators point to very subdued trends.  To the extent that inflation expectations have actually drifted down, it will take a period of overheating to re-anchor them.

The Recovery is not Done

It is important to emphasise that the recovery cannot yet stand on its own feet and monetary support is needed until growth momentum is strong and self-sustaining.

One recovery pillar is the improvement in credit flows, which obviously rests on monetary policy support.

A second pillar is the turning away from fiscal austerity towards mild fiscal expansion, which has been very much facilitated by monetary policy.

QE and outright monetary transactions (OMT) have diminished debt servicing cost for sovereigns and significantly reduced roll-over risk.

In addition to this, the bonds on the ECB balance sheet do not have to be covered by future bond issuance or a future increase in taxes for as long as they stay there.

If this period is expected to be long enough then this opens up considerable room for near-term fiscal easing.

Finally, an upturn in confidence also acts as an important driver for the recovery.

Monetary policy has also been helpful here as it provides a put option that protects EMU financial conditions from deteriorating on the back of rising political risks.

The ECB’s QE and OMT policies act as a substitute for burden sharing in the real economy and risk sharing in the fiscal space. Burden sharing is promoted because the policy stance should eventually translate into a feedback loop between higher core country inflation and lower core real rates.

This could indeed entail a further boom in core asset prices but core policymakers have only themselves to blame for this.

If they had implemented the first best solution of core reflation via fiscal policy and less wage restraint then yields would be higher today. Besides this, macro prudential policy should be the first port of call if these countries deem asset price inflation to be excessive.

Furthermore, a monetary union cannot function without some form of fiscal risk sharing because otherwise depressed regions will get stuck in a feedback loop between falling inflation and rising real rates.

There is thus plenty of reason to hold on to the current monetary policy stance in the foreseeable future.

However, this is not to say the environment has not changed for the better in the past few months and of course the ECB does recognise this in its communication.

The central bank is faced with a very delicate balance here: Some form of recognition that prospects have brightened will serve to strengthen the private sector but if the central bank does this too forcefully it runs the risk of tapering expectations being brought forward.

If that happens, the result could be an unwarranted tightening of financial conditions.