PIMCO expects no policy changes at the ECB Governing Council meeting on Thursday, aside from a minor adjustment to the bank’s outlook for growth. We think ECB President Mario Draghi will repeat the message that although the economic recovery is gaining momentum, risks remain, and that the improving outlook for inflation continues to depend on prolonging the bank’s ultra-accommodative policy stance.
No policy change…yet
Three factors argue for no major policy changes just yet:
- First, geopolitical risks in the eurozone have not been eliminated, even if they diminished last Sunday following Emmanuel Macron’s victory in the first round of the French presidential elections;
- Second, inflation has yet to fulfil all four criteria outlined by Draghi as prerequisites before withdrawing stimulus; and
- Third, Draghi was obliged earlier this month to rein in expectations for a speedier exit triggered by some national central bank governors.
These factors point to leaving forward guidance broadly intact, specifically the wording that policy rates will stay “at present or lower” levels and that the risks surrounding the GDP growth outlook “remain tilted to the downside.”
Tapering in 2017 still likely
That said, Draghi has already started to hedge out these downside risks, stating in March that they have “become less pronounced”. Ongoing improvements in eurozone growth data and diminished geopolitical risk since then do indeed warrant bolder acknowledgement of the better macro environment sooner or later. The ECB otherwise risks entrenching unduly depressed expectations about growth and inflation.
In terms of what this means for policy, our baseline forecast is that the ECB will end quantitative easing (QE) by June 2018, with the following sequence of actions:
- Change forward guidance to reflect a more symmetric policy stance at the 8 June 2017 meeting;
- Taper asset purchases at the 7 September 2017 meeting, effective in January 2018, ending QE by the end of June 2018;
- Begin normalizing the Deposit Facility rate in the first half of 2019; and
- Reinvest proceeds from maturing assets throughout this period, allowing its balance sheet to passively run down from 2020 onward.
Wages are not responding to lower unemployment, even in strong countries that have little spare capacity in their labour markets, making achieving the ECB’s close-to-2% inflation target simply by purchasing financial assets challenging. While QE has significantly supported aggregate demand, it is not costless, neither in terms of financial stability nor equity. The longer QE drags on, the more these costs rise.
The EU Treaty mandates the ECB to achieve price stability, but monetary policy alone has limited influence in an open economy over important determinants of inflation like wages and oil. Accounting for both the costs and benefits of ultra-loose monetary policy therefore argues for a flexible interpretation of the inflation target.
A fortuitous coincidence
The ECB’s aggregate holdings of member states' government bonds will approach one-third by the end of this year and are on track to hit the binding 33% issuer limit in multiple countries during the first half of 2018. This technical limit, which is fortuitously coinciding with robust economic growth by eurozone standards, effectively forces the ECB to taper QE early next year come what may.
Unless it stops QE abruptly, however, stretching QE deep into 2018 will require the ECB to deviate the distribution of member state government bond purchases away from its capital key. Relaxing the capital key is controversial. Aside from legal issues, we think it would only find support in the Governing Council once the ECB has committed to wind purchases down to zero in short step.
As the flow of QE liquidity ebbs, we think it will make the asset prices most dependent and distorted by monetary policy, like periphery government bonds and Bunds with short maturities, vulnerable, and we thus remain cautious on these sectors.
Andrew Bosomworth is PIMCO’s head of portfolio management in Germany and a regular contributor to the PIMCO Blog.