ECB Must Strike Right Balance in Scaling Back Bond Purchases

European Central Bank President Mario Draghi overcame fierce resistance three years ago to roll out a historic bond-buying program. Ending it could be an even more delicate task.

On Thursday Mr. Draghi is expected to lay out the ECB’s plans to scale down its bond purchases, known as quantitative easing or QE, which economists credit with helping to strengthen economic recovery across the 19-nation eurozone.

Move too quickly, and Mr. Draghi risks an adverse financial market reaction that could derail the recovery — and might even rekindle its sovereign-debt crisis. Move too slowly, and investors could be left doubting whether the ECB has drawn a line under its bond purchases.

Investors are on edge. “One loose word could destroy months of work,” said Stefan Gerlach, a former deputy governor of Ireland’s central bank who is now an economist at EFG Bank in Zurich.

The ECB is navigating between a weak outlook for inflation and a looming shortage of bonds that it can buy under self-imposed rules for QE. It also faces conflicting political pressures around Europe to continue to support the economic recovery, or to exit its stimulus programs soon.

The ECB’s dilemma echoes that of other major central banks, led by the Federal Reserve, which are finally edging toward higher interest rates after a decade of stimulus measures. Many investors worry about hidden problems that might come to light as governments and businesses finally face up to higher interest rates, including potential asset-price bubbles, and “zombie” firms that survived artificially on low rates. Eurozone firms and households haven’t reduced their debt in aggregate since 2009, according to Commerzbank, meaning that many could struggle as rates rise.

How to exit from the EUR2.3 trillion QE program will be the ECB’s fourth momentous decision of Europe’s crisis-racked decade since 2007. It follows emergency lending to banks, its “whatever it takes” pledge to prevent the collapse of the euro, and the launch of QE in early 2015 to prevent a slide toward deflation.

Mr. Draghi is expected to try a sleight of hand, telling global markets that the ECB will extend its bond purchases deep into 2018 while reducing the monthly amounts from EUR60 billion to EUR20 billion or EUR30 billion — but also trying to convince investors that nothing has changed.

That would echo a move by the ECB a year ago to reduce the pace of its purchases while arguing that the QE stimulus policy was continuing.

If successful, QE’s termination would mark a big step in the eurozone’s return to normality. If mishandled, it could leave the $12.5 trillion eurozone economy with fresh chronic problems — and with fewer tools to fix them.

Mr. Draghi’s task on Thursday is even trickier than the balancing act that faced the Fed when it wound down its own QE program almost four years ago. The ECB has had to buy bonds more aggressively than the Fed to stimulate the eurozone economy, because economic activity is less sensitive to financial asset prices than in the U.S., economists say.

Purchases of U.S. government bonds never exceeded their net issuance, whereas for the ECB, QE is currently seven times bigger than net issuance of eurozone government debt, according to Torsten Slok, an economist with Deutsche Bank in New York.

The ECB’s balance sheet is also significantly larger as a share of gross domestic product — 40% of eurozone GDP, versus 24% for the Fed. That means the ECB’s exit could create bigger ripples than the Fed’s, which triggered a “tantrum” in global bond markets four years ago.

The ECB faces an additional hurdle: It is running out of bonds to buy. Policy makers say they are prepared to use up all of the remaining stock of eligible bonds — some EUR300 billion — in a final effort to drive up stubbornly low inflation.

But top ECB officials are deeply divided over whether to announce a concrete end date for QE on Thursday, or to leave open the prospect of a fresh extension.

The ECB’s purchases have kept a lid on borrowing costs for highly-indebted southern European governments such as Italy, helping to guard against a return of the region’s sovereign-debt crisis. As the ECB exits bond markets, there is a risk the debt crisis could return.

“The root causes of the sovereign-debt crisis have not yet been solved in Italy, this is what makes the ECB’s exit so complicated,” said Jörg Krämer, chief economist of Commerzbank in Frankfurt.

Italy’s central bank governor Ignazio Visco warned in an interview last week that it would be “foolish” to fix an end-date in the face of economic risks that could trigger a sudden change in the outlook.

Even though the ECB has been extremely careful to prepare the markets for a policy change, doubts linger over how southern European countries will adjust to higher interest rates, particularly as the Fed also moves in the same direction, said Lena Komileva, chief economist with G+ Economics in London.

Even critics of QE accept that the program has helped boost the economy, by compressing a range of market-interest rates and thereby stimulating lending and growth. The region’s unemployment rate has fallen from around 12% to 9% since QE was announced, and business and consumer confidence are at postcrisis highs.

Jens Weidmann, the German Bundesbank president who publicly broke ranks to attack QE when it began, might support an extension of the program this week, the first time he would have done so, according to a person familiar with his thinking.

The sticking point for the ECB is inflation, its actual target. Core inflation, which excludes volatile food and energy prices, has hardly budged since the start of QE, rising to 1.1% from a trough of 0.6%. The ECB doesn’t expect inflation to reach its target of just below 2% until at least 2020.

Publicly, ECB officials argue that their policies will succeed eventually in pushing up inflation. But privately, they are divided over whether QE can ultimately push inflation higher, according to a person familiar with the matter.
Source: Dow Jones

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