The ECB – Not the time for tapering

Since the start of 2015, ECB QE has stamped its mark on euro area financial markets. Having so far bought more than €1trn of public sector bonds, about €200bn of covered bonds, and almost €50bn of corporate bonds and ABS, the ECB has intentionally driven yields sharply lower, significantly easing financial conditions. Indeed, interest rates on new loans to non-financial corporations and households in the euro area have recently fallen to record lows, supporting a steady pick up in bank lending. With the declines in interest rates steepest in Southern Europe, QE has also helped to repair the financial fragmentation of the euro area that fuelled fears about the sustainability of the single currency. And while the full economic impact of the purchase programme is hard to quantify, one recent ECB study suggested that it has given a boost of more than 1ppt to euro area GDP and almost ½ppt to inflation.

But ahead of the ECB’s forthcoming policy announcement on 20 October, the future of its QE programme has become a matter of conjecture. The ECB’s current policy settings involve it buying about €80bn of assets per month at least until the end of March 2017. But motivated by concerns about the scarcity of bonds available to purchase, due primarily to the large volume of securities with yields below the -0.40% minimum rate, it decided last month to review options to ensure QE’s ‘smooth implementation’, suggesting that amendments are in the pipeline. And media reports have suggested that there was a growing consensus on the Governing Council that, before ending QE, the ECB would ‘taper’ its purchases, reducing the amount of assets bought, perhaps in increments of €10bn per month – a decision that could, of course, help to address concerns about bond scarcity.

But is the ECB really ready to taper its purchases? We doubt it.

When the Governing Council eventually decides that the economic outlook no longer warrants asset purchases of €80bn per month, it is highly unlikely to bring an immediate halt to the programme. Instead it would of course elect for a gradual taper of its asset purchases, with reductions of about €10bn per month, broadly in line with the actions of the Fed in 2014, perfectly feasible. But unless the economic outlook is sufficiently robust when the policy shift is announced, the resulting upwards shifts in bond yields and likely appreciation of the euro would still have a non-negligible negative economic impact.

Indeed, the ECB has repeatedly acknowledged the importance of maintaining highly supportive financial conditions in order to push inflation higher over the coming two years. To illustrate the point, its most recent forecasts – which predicted that inflation would reach 1.6%Y/Y in 2018 – were based on the assumption that the average 10Y euro area government bond yield would be lower in 2017 than in 2016 (and indeed lower than the current level) while the euro exchange rate would remain little changed. Any tightening of financial conditions relative to that baseline would imply a weaker inflation outlook.

Recent data suggest that euro area GDP growth is being maintained close to the 0.3%Q/Q rate of Q2. And in the absence of shocks, similar moderate growth rates seem likely to be sustained. That’s better than nothing. But it won’t suffice for the ECB to meet its inflation target. As the impact of past falls in oil prices fades, euro area inflation is set to rise gradually to close to 1%Y/Y around the turn of the of the year and a little higher still in 2017. But while Mario Draghi suggested that the ECB’s target of “below, but close to, 2%Y/Y” might subsequently be reached by late 2018 or the beginning of 2019, key data suggest that – unless the oil price jumps sharply higher – CPI will struggle to rise above 1½%Y/Y. Of particular concern is the persistent weakness of core inflation, which at just 0.8%Y/Y in September remains near the bottom of the range of the past year. Meanwhile, the softening of wage growth to below 1%Y/Y in Q2 and the associated flat-lining of the unemployment rate above 10%, means that underlying inflation pressures from the labour market appear to be decreasing.

The economic outlook therefore does not merit a reduction in monetary policy support. And the risks to the outlook look very much skewed to the downside, with no shortage of banana skins – many of them political in nature but capable of increasing economic uncertainty and generating investor volatility – to be dodged over coming months. Among the more notable, the Italian constitutional referendum on 4 December risks triggering a political crisis in the euro area’s most vulnerable large member state, while the Austrian Presidential election the same day might yet see a far-right populist established as Head of State. In March, the Dutch general election similarly risks a swing towards the political extremes at a time when campaigning in the French Presidential election set for April and May will also be well underway.

Also by March, UK Prime Minister May intends to have invoked Article 50 to launch negotiations to leave the EU. While UK GDP growth in Q3 was probably still about half the 0.7%Q/Q rate of Q2, a further slowdown lies ahead. Indeed, the recent plunge in sterling provides a guide to investors’ rapidly deteriorating perceptions of economic prospects in the country, which rivals the US as the most important for euro area exports. And the ECB knows that the self-harming ‘hard Brexit’ pursued by May risks significant economic and financial consequences both within and beyond the UK.

So, given the underwhelming economic outlook and heightened risks, without a marked firming of the economic data, the ECB would be foolish to announce an intention to taper within the coming six months. Instead, expect an eventual extension of QE at the current rate beyond next March, probably initially for a further six months.

Given the difficulties it already faces sourcing bonds, an extension of purchases means that it will also need to introduce greater flexibility into the purchase programme’s parameters. But, with many options seemingly unpalatable, the Governing Council won’t find it easy to reach agreement on the precise adjustments to be made. And there won’t be any announcement this month. But, in due course, the ECB will likely agree to increase the share of any bond issue that can be bought under the programme, while also perhaps making explicit its tolerance of deviations – which already occur – of purchases from its capital key. Purchases of bonds yielding less than -0.40%, however, seem less likely. Expect an announcement of those rule changes in December when the ECB’s updated forecasts will also make clear the case for prolonging QE and keeping bond yields low for longer.

*This article was originally written for and published in Japanese by NNA Europe (

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