The eurozone economy is getting stronger, the deflation threat has disappeared, corporate earnings are growing, and optimism has taken hold in households and among businesses.
Sounds like the perfect time to announce the end of quantitative easing, when the European Central Bank meets for its highly anticipated meeting on Thursday, right? But there’s just one problem: the euro EURUSD, +0.2518% and its almost 15% rally this year to a more than two-year high against the dollar.
“The stronger euro has made the ECB’s taper tiptoeing even more complicated. While a clear hint on tapering at this week’s meeting could send the euro even higher, potentially undermining the recovery, room to postpone tapering is limited due to bond scarcity,” Carsten Brzeski, chief economist at ING, said in a note.
The ECB is “stuck in the euro trap,” he said.
Since ECB President Mario Draghi said in July that policy makers would discuss QE’s future “in the autumn,” analysts have speculated an announcement would come at the September policy meeting because it coincides with the new ECB staff forecasts. The current program of buying €60 billion euros’ worth of bonds a month is slated to run until the end of the year, but the ECB has kept the door open for an extension.
Few people expect the central bank to end the bond-buying program altogether at the end of the year, but the question is how long it’ll be extended for and when the tapering will begin. Looking at the state of the economy, several factors suggest Draghi & Co. can take their foot off the QE gas pedal.
Second-quarter growth in the eurozone came in at 0.6%, pointing to growth above 2% for the full year. Not a single member state produced negative economic growth last quarter, and traditional laggards such as Italy, France and Greece appear to be on a more stable recovery path.
Additionally, while inflation is not as high as the ECB would like it to be, consumer prices are rising significantly faster than in recent years. Headline inflation is expected at 1.5% in August, compared with 0.2% in August last year and the recent low of negative 0.6% in January 2015. The ECB’s annual inflation target stands near but just below 2%.
Euro causing headache in Frankfurt
But the strong euro is causing headaches in Frankfurt, by damping the economic recovery and inflation.
A stronger exchange rate is bad news for exporters as it means their products become more expensive for other currency holders, potentially leading to slower sales and thus slower economic growth.
Because imports becomes cheaper, a rising euro can also lead to weaker inflation, which is one of the ECB’s biggest concerns. A 10% appreciation in the euro versus the dollar could take 30 basis points, or 0.3 percentage point, off the inflation rate over the next six quarters, according to Société Générale.
A Reuters report last week said the rising euro is worrying more policy makers, leaving an announcement on QE tapering at Thursday’s meeting highly unlikely. The report said an announcement might not be ready until December.
The report came just a few days after the shared currency climbed above $1.20 for the first time since January 2015. The ECB is not mandated to target the exchange rate, but some analysts are growing frustrated that the central bank won’t admit that’s exactly what it is trying to do. The euro traded at $1.1930 on Wednesday.
“Just as Mario Draghi and his colleagues at the ECB were watching in disbelief as euro-dollar headed back towards $1.20 and looked like easing past it, ‘ECB sources’ came to the rescue and the move was quickly reversed,” said Craig Erlam, senior market analyst at Oanda, in a note.
“This may be the skeptic in me, but it would seem the central bank is paying far too much attention to its FX rate and may now even be planning its tapering announcement around it, or at least using it as a tool to hold back the currency,” he added.
The problem for the ECB is, however, that they can’t keep buying eurozone bonds forever. Regardless of the strength of the economy, the bank is simply close to running out of eligible paper to buy, which makes some kind of tapering almost unavoidable in 2018, according to Brzeski from ING.
That leaves the ECB with two options on Thursday, he said. The bank either announces the details of a “very dovish tapering” that will start in January 2018, hoping that some kind of clarity will restore calm in the markets. Or it will strike a cautious balance and provide QE hints, but at the same time adopt a dovish stance, such as warning against “unwarranted tightening of financial conditions.”
“As the ECB is probably not yet unanimous on the first option, we expect that Thursday’s meeting will again be about what Draghi did not say, rather than what he did,” Brzeski said.
ING forecasts that the central bank will reduce its monthly bond purchases by €20-30 billion, from January until at least June 2018. If the euro climbs even further, the taper could shrink to €10 billion, according to the bank.