ECB has multiple dilemmas with monetary easing

The European Central Bank (ECB) is unnerving markets by remaining vague over the future of its bond-buying scheme. Yet, if investors listened carefully, they would detect an emerging framework for understanding what guides policymakers. The first principle is that the ECB has gone “data dependent” over its quantitative easing (QE). Whereas previously central bankers had said that bond purchases would continue until the end of 2017, for now they appear more reluctant to tie their hands over what will happen next.

It will take at least until September before central bankers make clear whether they will reduce the pace of asset purchases from €60 billion a month.

This decision reflects an open debate within the governing council about how much weight to give conflicting indicators. For example, while economic activity and confidence remain strong and unemployment continues to fall, the recovery has had only a limited impact on prices: at 1.3 per cent, inflation is still below the ECB’s target just below 2 per cent.

This does not mean investors have nowhere to look. In fact, two sets of indicators stand out. The first is the labour market: There is no sign that wages are rising fast, as they would if the labour market were overly tight.

That suggests that unemployment still has further to fall without stoking inflation, which in turn makes it less urgent for the ECB to tighten its monetary policy.

The other indicator is the price of oil: While the ECB is primarily concentrating on core inflation — which ignores volatile items such as energy — this distinction can often be artificial. Were energy prices to resume their fall, there will inevitably be spillovers to core inflation, which will make the ECB more prudent about exiting QE.

The second principle investors should note is that the ECB may well be creative in how it tapers QE.

This means deviating from the textbook of the US Federal Reserve, which cut back its asset monthly purchases by roughly $10 billion after each Federal Open Market Committee Meeting between the end of 2013 and 2014. In a recent interview with two European newspapers, Benoit Coeure, an executive board member, pointed to the decision the ECB took last December to scale back asset purchases while extending their horizon, as a possible model for the future. The ECB could therefore announce that QE will be reduced to, say, €40 billion a month … but extended for another six months. This would bring the central bank closer to the termination of net asset purchases, while giving the eurozone economy more time to recover.

One problem with this strategy is that the ECB has committed to purchasing sovereign bonds in accordance with its so-called “capital key”, which determines how much each country contributes to the central bank and is used to work out how much of each country’s bonds can be purchased.

This means buying sizeable amounts of German or Dutch sovereign bonds, even though these have become scarcer — partly because of other rules constraining the central bank purchases. While the ECB can introduce some flexibility to the rules, this will be politically difficult to sell in capitals such as Berlin. But what, it’s worth asking, about the impact of political events on the ECB’s decision to taper QE?

Concern over Italy

The biggest worry is of course, Italy, which will hold a general election in the spring of 2018. The three-way split in Italy’s politics between the centre-left, centre-right and the populist Five Star Movement, means the vote is unlikely to produce a stable government.

This could spook markets, causing a rise in the spread between Italian and German sovereign bonds. Would an Italian crisis send data-driven banking out the window?

That’s unlikely. As the eurozone’s third largest economy, Italy obviously can’t be ignored when it comes to decisions about tapering. However, all indications from Frankfurt are that the central bank will take its decisions on the basis of economic considerations alone.

As ECB President Mario Draghi said in his last press conference, the central bank’s mandate “is specified in terms of price stability. It’s not specified in government budget support or other considerations.” Were Italy to run into trouble, there would be other tools at the ECB’s disposal. These include the “outright monetary transactions” programme, which involves targeted bond purchases for a country in difficulty in exchange for a programme of reforms.

The ECB faces a delicate balance between communicating its intentions and being able to adapt to evolving circumstances. As they prepare for the autumn, investors should be patient: Better to have a flexible central bank than one that commits to the wrong path and then has to make amends.