Based purely on the European Central Bank’s (ECB) latest inflation forecasts of 1.3% for 2017, 1.5% for 2018 and 1.7% for 2019 (these are year-over-year forecasts for Europe’s Harmonised Index of Consumer Prices), logic would appear to suggest the ECB should maintain its current ultra-loose monetary stance well into next year and beyond. After all, even the 2019 forecast is only just consistent with the ECB’s definition of price stability (i.e., inflation rates below, but close to, 2% over the medium term), and core inflation remains sluggish.
However, monetary policy does not exist in a vacuum; it co-exists alongside fiscal and structural policies and it needs to consider financial stability. Monetary policy contributed substantially to the world’s and Europe’s recovery from the financial crisis and even more so of late than fiscal and structural policies, which have waned. Yet the efficacy of monetary policy is declining, and the risks to financial stability from a misallocation of resources are rising the longer monetary policy continues in its current form. And despite subpar core inflation, growth in output is closing in on the eurozone economy’s potential.
Furthermore, our analysis suggests that the rules it has set itself for the purchase of sovereign debt leave the ECB with no other choice but to taper purchases of government bonds further beginning early in 2018. In fact, we think it will have to cease buying central government sovereign bonds in some smaller countries altogether in the first quarter of 2018 if it is to respect both the 33% issuer and issue limits. Only by relaxing these constraints and the capital key rule, or by purchasing other assets, could quantitative easing (QE) be extended beyond the second quarter of 2018, according to our estimates. Assuming the ECB respects the 33% limits and capital key, PIMCO expects it will taper QE purchases to €40 billion per month in the first quarter of 2018, to €20 billion per month in the second quarter, and then finally end QE in June 2018. We think the decision to taper further in 2018 will be communicated at the September 2017 meeting, and we expect a change to forward guidance on policy rates in the course of this year, possibly as soon as the June 2017 meeting.
Balancing policy risks
There is a strong case for the ECB to continue tapering its QE programme, to alter its forward guidance and to begin normalising policy rates. While these changes will tend to tighten financial conditions, this risk is outweighed by the growing risks to the region’s financial stability. And the risk of tighter financial conditions is at least partially offset by a stronger U.S. dollar, narrower credit spreads and rising real estate prices. Continuing to taper QE would also send a signal to fiscal agents that they too can contribute to boosting growth.
Andrew Bosomworth is PIMCO’s head of portfolio management in Germany and a regular contributor to the PIMCO Blog.