The European Central Bank is still injecting massive amounts of cash into the euro zone’s economy. At some point, it will have to stop. The U.S. central bank is already well underway with its pullback and offers lessons on what to do – and what not to do – when the time comes.
At an annual gathering of economists, academics and European central bankers in Germany’s financial capital Frankfurt last week, one word was on everybody’s lips: “Sequencing.”
It’s a technical term for a simple question: How should authorities like the European Central Bank go about exiting from their extremely loose monetary policy since the financial crisis?
German savers, suffering under record low interest rates designed to help revive southern European economies, have been hoping to see the start of it for years – and have so far been frustrated: “A reassessment of the current monetary policy stance is not warranted at this stage,” ECB President Mario Draghi said at the Frankfurt conference, dashing speculation building over the last month that a turnabout may already be on hand.
With those words, Mr. Draghi was also distancing himself from his counterparts across the Atlantic. Janet Yellen, chair of the US Federal Reserve, has been dialing back at full steam over the past two years, raising interest rates off record lows thanks to a US economy that has recovered from the 2008 financial crisis far more quickly than that of Europe.
The time may not yet have arrived for Europe to do the same, but everybody is thinking about it. And the Federal Reserve offers some key lessons on how to go about it when the time comes – lessons that Mr. Draghi is already putting into practice.
“One of the lessons is that you have to be very careful when you take a step that can sound like it can be followed by another step.”
John Williams was taken on a trip down memory lane listening to the “sequencing” discussion at last week’s Frankfurt conference. It’s a dilemma he remembers well. As head of the San Francisco Federal Reserve, one of 12 central banking districts in the United States that have a say in monetary policy, he was part of the same discussions at the US central bank.
That doesn’t mean he has any easy answers as Frankfurt starts to ponder the very same questions he did some three years ago: “Oh boy! These are really hard decisions,” he says, flashing a knowing smile when asked in an interview what the ECB can learn from the Federal Reserve’s experience.
And there are definitely things to get wrong – or at least to communicate badly. That might be the biggest lesson for ECB President Draghi as he moves forward.
Just ask Ben Bernanke, the former Fed chairman, who sparked a massive market backlash in September 2013 when he first suggested the US central bank was preparing to wind down a monthly “quantitative easing” bond-buying program that had been propping up the US economy, swelling the central bank’s balance sheet to more than $4 trillion in the process. Financial markets were caught off guard and interpreted his words as the beginning of the end of the Fed’s easy monetary policy, when all Mr. Bernanke really wanted to say was that he planned to ease off the throttle. The moment became known as the “taper tantrum.”
“It was sold as only a light turning of the screw that wouldn’t have any effect on the overall direction of monetary policy. But it led to the markets completely reevaluating the direction of monetary policy and preparing for an earlier rise in interest rates,” Jan Hatzius, chief economist of Goldman Sachs, said in an interview with Handelsblatt. “The consequence was serious turbulences, above all in emerging economies, but also in the United States.”
Three years later, the European Central Bank is essentially at the same stage in the process. After more than two years of running its own quantitative easing program, which has involved buying up more than €1 trillion in government and corporate bonds to spur lending, the ECB has said it will start winding down the program at the start of next year.
So far, the markets have been taking the ECB’s announcements in their stride. Unlike three years ago when Mr. Bernanke announced that the end of his QE program was near, markets are seeing the ECB’s stance as more dovish. The trick, says Mr. Williams of the San Francisco Fed, is making clear to markets that you’re not going further than you really are.
“One of the lessons is that you have to be very careful when you take a step that can sound like it can be followed by another step,” Mr. Williams told Handelsblatt. In other words, Mr. Bernanke’s ‘taper tantrum’ was largely the result of markets linking a slowdown in bond-buying with the start of raising interest rates.
Mr. Williams said the Fed’s “taper tantrum” forced the US central bank to lose flexibility. Rather than make the same communication mistake when it actually began tapering months later, the Fed chose to spell out exactly how it would reduce QE: “We lost that optionality to adjust it, but it did reduce the [market] uncertainty.”
In other words, the Fed traded flexibility for clarity. But Mr. Williams suggests that if the ECB can do a better job of getting the balance right, it may have a better chance to keep more control over the process. “There is no general right answer. I think it is just a trade-off,” he said.
Flexibility is something the ECB may actually want. The path of the 19-nation euro zone’s recovery is still very uncertain. If it tanks again, the ECB may want to keep its QE program going. If the economy improves faster than expected, it may want to exit quicker without causing a market meltdown.
Every central bank is different, of course. The ECB says there’s no overt coordination between the two central banks. And yet, ECB President Draghi probably had Mr. Bernanke in mind when he stepped in with his rather forceful statement last week. In his speech, he quashed any speculation that the ECB would raise interest rates at the same time that it dials back its QE program.
Interest rates in the 19-nation euro zone have been kept even lower at the ECB than at the Fed. Not only is the central bank’s main refinancing rate at zero, but the ECB has pushed its deposit rate – the rate it charges banks that park their reserves with the central bank – into negative territory at -0.4 percent. It’s the latter rate that has drawn the ire of German bankers and where, until Mr. Draghi’s latest intervention, markets were starting to expect some changes.
“The biggest risk is that the markets abruptly change their interest rate expectations. That would have a strong impact on financing conditions. That is why the current debate about raising the deposit rate is dangerous.”
The message has reached Mr. Hatzius of Goldman Sachs. His expectation: The ECB will start pulling back its €60 billion-a-month bond-buying program in 2018, but only start raising interest rates in 2019. Yet it’s a fragile truce: “The biggest risk is that the markets abruptly change their interest rate expectations. That would have a strong impact on financing conditions. That is why the current debate about raising the deposit rate is dangerous,” he said.
It’s not just that the euro zone isn’t ready to follow Washington’s lead – in some ways the US exit makes the ECB’s job harder. Ms. Yellen’s Fed is widely expected to raise interest rates at least three more times this year to a rate of around 1.5 percent. If markets were to interpret U.S. tightening as a sign that the euro zone was following with its own tightening, that could be a problem by driving up long-term yields earlier than the ECB wants.
Philip Lane, governor of the Irish central bank, suggests the ECB will therefore have to actively work against perceptions that the euro zone will follow the US out the easing door.
“The ECB can do a lot to insulate European monetary conditions from a tightening in the US,” Mr. Lane said in Frankfurt.
While Europe may have to react to the US Fed exit, central bankers tend to shrug off the need for any overt coordination of the unwinding process across the Atlantic. “As long as each individual central bank is trying to pursue its own domestic mandate… that should provide the legitimate anchor for a central bank’s actions,” Thomas Laubach of the US Fed said in Frankfurt.
Hans-Helmut Kotz of the Center for Financial Studies in Frankfurt, suggested that rather than coordination, there’s an indirect effect from central banks taking the same approach to the same problems. “Apparently coordination happens somehow by default, it appears to me,” he said. Central bankers in Europe, the US and even Japan “have pretty similar views of the world and how the world works. Hopefully this coordination happens by using the same approach….and using the appropriate tools.”
Christopher Cermak is an editor with Handelsblatt Global in Berlin. He has also worked in Frankfurt and Washington covering the Federal Reserve and European Central Bank. Jan Mallien of Handelsblatt in Frankfurt contributed to this story. To contact the author: Cermak@handelsblatt.com