ECB Shadow Council

It Pays To Wait

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A coy smile won't be enough come October. Source: Reuters

Mario Draghi reportedly celebrated his 70th birthday away from Frankfurt last weekend, and with good reason. Germany’s financial capital was the site of the largest evacuation in post-war German history as disposal experts defused a massive World War II-era bomb discovered at a building site.

An appropriate metaphor perhaps, particularly for German policymakers, who fear that the ECB president is sitting on a ticking time bomb in the form of trillions or euros in cash injected into the euro zone’s economy. Over the coming year, Mr. Draghi will have to defuse that bomb by carefully weaning the economy off the stimulus the ECB has been providing for nearly three years.

It’s a delicate process, and one that could lead to some sharp disagreements among the ECB’s governing council members when they hold their latest rate-setting meeting Thursday in Frankfurt. But while sparks may fly, most economists don’t expect the council to make any decisions on how to actually proceed until next month.

There’s good reason to wait on how to proceed. The biggest reason: It could halt a record rise in the value of the euro.

“Like any medication there are side effects, and these are growing.”

Martin Zielke, Commerzbank CEO

It’s true that some economists are demanding the ECB immediately start winding down its bond-buying program, which currently involves buying some €60 billion in government and corporate debt across the euro zone in a bid to boost prices and growth in Europe (see graphic below). “I favor an immediate halt to asset purchases,” said Willem Buiter, chief economist of Citigroup and a member of the Shadow Council, a group of economists convened quarterly by Handelsblatt to sound off on the ECB’s next moves.

But Mr. Buiter is an outlier. Most economists expect the central bank to keep its monthy program going at least until the end of the year and to slowly start cutting back on the pace of the monthly purchases in the first half of 2018.

Even so, many economists agree the euro zone doesn’t really need the help anymore. Marco Annunziata, chief economist of General Electric, notes the euro zone’s current growth rate of around 2 percent is well above its potential, meaning it doesn’t need additional cash from the ECB to keep running. Meanwhile, financial risks have increased, since record low interest rates force banks and investors into more dangerous products to earn their keep. “Like any medication there are side effects, and these are growing,” Commerzbank CEO Martin Zielke told Handelsblatt.

But there is the matter of credibility. The ECB has already said it will keep the program running at its current monthly pace through December. Changing course now would shock financial markets. That’s one reason most economists don’t expect the ECB to lay out its plans for 2018 on Thursday. “The ECB clearly doesn’t need to be in any rush in terms of tightening policy,” said Elga Bartsch, chief European economist of Morgan Stanley and another member of the ECB Shadow Council.

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Waiting until October has other benefits, according to Ms. Bartsch. It gives the central bank more time to gather information on how the 19-nation euro zone’s economy and financial conditions are shaping up for the rest of the year. Waiting also allows the ECB to play a bit of a cat-and-mouse game with the United States – and thereby affect the path of the euro currency. Before the ECB’s next meeting in October, the Federal Reserve will hold its own meeting to decide whether or not to raise interest rates in the United States.

The Fed has already blazed a trail for the ECB. The US central bank started cutting its own bond-buying program, known as quantitative easing, back in December 2013. It has also raised interest rates, which were brought down to a record low of 0 percent in the aftermath of the 2008 financial crisis, back up to a level of 1-1.25 percent. At a meeting later this month, the Fed will decide whether to raise interest rates even further.

The Fed’s decision matters for the ECB – because it matters for the dollar-euro rate. If the Fed raises interest rates and the ECB holds back, that could strengthen the dollar, which has fallen to an 18-month low against the euro. If the ECB were to start tightening its own policy first, the euro might appreciate even further instead. That could be difficult for export-oriented European companies – particularly in Germany – to accept.

And then there’s the unpredictable international scene. Will Donald Trump succeed in getting a tax reform or fiscal stimulus through Congress? That, too, could strengthen the dollar, and give Mr. Draghi more wiggleroom to decide on his own next move.

All good reasons for Mr. Draghi to wait on Thursday. And yet, the ECB president may at least give markets some signals to chew over, to prevent markets from placing all their chips on a decision in October. He could, for example, spell out a bit of his thinking on the process.

When it comes to that process, Mr. Draghi has three options. The first is to present a clear plan: The ECB could lay out exactly when and how it will reduce its monthly bond-buying plan to zero – for example cutting the monthly volume to €30 billion in January and to zero in March or June. The advantage is clarity, the drawback is the central bank won’t be able to adjust if something bad (or good) happens to the euro zone’s economy in the meantime.

Option 2: a fully-flexible approach. Cut bond-buying in January to €30 billion or €40 billion and say nothing about the future. That gives the ECB wiggleroom, but allows markets to go wild predicting what their next move is in the meantime. Option 3: a compromise. Reduce bond-buying in January and set a date – March or June – to review and cut further depending on the state of the economy.

Nobody said it was going to be easy. At least Mr. Draghi should have another month to think about it.

Christopher Cermak is an editor with Handelsblatt Global, currently based in Washington DC. Jan Mallien is a correspondent for Handelsblatt based in Frankfurt. To contact the authors: cermak@handelsblatt.com and mallien@handelsblatt.com

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