The European Central Bank’s (ECB) monetary policy decisions ought to be fairly straightforward for the next year or so. After 2020, however, the central bank will face a more complex set of challenges. In PIMCO’s baseline forecast, the ECB tapers its asset purchase program from €30 billion per month currently to zero by the end of 2018, followed by a 15-basis-point increase in the deposit facility rate to −0.25% in the middle of 2019.
Then, if we’re correct that eurozone economic growth persists and unemployment falls further, the ECB should be able to raise interest rates on all three standing facilities by a quarter of a percentage point at the end of 2019, taking the deposit facility rate to zero and the main refinancing rate to 0.25%. For ECB President Mario Draghi, who effectively saved the euro in 2012, bringing policy rates back to zero would be a fitting end to his term in October 2019.
President Draghi’s successor will face a different set of challenges. One will be the extent to which the ECB can normalise policy rates before the U.S. and eurozone economies eventually fall into recession. A second challenge will be calibrating the instruments through which the ECB implements monetary policy.
A complicating factor lies across the Atlantic, where the U.S. Federal Open Market Committee (FOMC) projects it will raise the fed funds rate to 3.4% by 2020. Forward interest rate markets, however, imply the FOMC will stop raising rates in 2020 with the policy rate landing between 2.5% and 2.75%, while the ECB continues to hike rates all the way to 1.75% – years after the FOMC has gone on hold (see chart). All three projections cannot be simultaneously correct.
We tend to think the market overestimates the extent to which the ECB can normalise policy rates. Gross exports of goods and services made up 47% of eurozone national income in 2017. Europe’s dependence on external demand will limit the extent to which the ECB can raise rates beyond zero once global growth slows down.
Policy tools in the next recession
With limited scope to cut policy rates, therefore, the ECB will have to use its balance sheet to counter deflationary pressure when confronted with the next recession. PIMCO expects very long-term refinancing operations (LTROs) to become a standard tool of monetary policy once the current LTROs begin maturing from September 2018 onward. Fixed-rate, full-allotment auctions, whereby the ECB lends banks all the liquidity they demand against collateral, also look set to remain part of the standard policy toolkit – at least so long as the ECB reinvests maturing bonds bought under its asset purchase programme, which we anticipate it will do at least until 2020.
With policy rates near zero or only slightly higher when the next downturn occurs, one way for the ECB to lower the term structure of interest rates, thereby reducing firms’ borrowing costs, would be to receive interest rate swaps while buying private sector assets. But so long as the eurozone lacks a centralised fiscal capacity and common deposit insurance, firms – particularly banks in periphery countries – and their sovereigns will remain interlinked. This leads us to conclude the ECB will have to dispense with its self-imposed limit of buying only up to one-third of member states’ government bonds.
Macroprudential policies that regulate how much banks can lend borrowers to buy property, relative to the purchase price or relative to the borrower’s income, could help the ECB maintain financial stability in its pursuit of price stability. With consumer price inflation lagging house price inflation, macroprudential polices would give the ECB more time to normalise policy rates while curbing the risks of a housing price bubble.
Whatever way we look at it, Europe’s unconventional policies and low levels of interest rates are likely to persist. For the eurozone’s short-term markets in particular, the years ahead of above-zero interest rates might be but a brief interlude to a new phase of unconventional monetary policies.
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Andrew Bosomworth is PIMCO’s head of portfolio management in Germany and a regular contributor to the PIMCO Blog.