ECB: Euro, QE Adjustments, and Succession

Published on August 30, 2017

*** The Euro at 1.2000 is no surprise to ECB officials – but if it keeps rising and accelerating the currency will clearly adversely affect inflation forecasts. A good deal of the Euro rise to date is of course fine in that it has reflected the positive outlook for Eurozone growth, markets, plus what is an interesting new observable safe-haven trade at times into the Euro.

*** ECB officials can comment on the currency, but know the impact of their comments will be limited, as the Governing Council will soon be lowering accommodation and adjusting the rate of bond purchases downwards for 2018. The strengthening Euro has, however, already impacted policy in that the ECB will NOT be making a decision on the 2018 QE program at the upcoming September 7 meeting, but will assign task forces to study different options and defer that decision to its October 26 Governing Council meeting.

*** While no decision on a new program has or will be made until October, it is likely the new QE plan – once the current 60 billion Euros/month program runs out in December – will run through the course of 2018, with a break at the six-month mark to reassess or adjust the program if need be. In other words, we believe the ECB is unlikely to plan a taper of bond purchases to zero before the end of 2018.

*** Separately, speculation over ECB President Mario Draghi’s succession once his term runs out in October 2019  has already begun, with all the press and market focus on Bundesbank President Jens Weidmann. While Weidmann is a strong candidate and reasonable guess, expect also a push from France and other member states alternatively for Board Member Benoit Coeure, who has been a steady hand at the helm of the Executive Board alongside Draghi and Chief Economist Peter Praet.

The Euro and ECB Policy

In addition to all the obvious reasons for the impressive four-month rally of the Euro, ECB officials point to an interesting development with the Euro, which seems to have found a sort of safe-haven status … markets seem now to buy Euros and sell Dollars when risk goes up.

Regardless, the Euro is strong but its strength is not surprising… in line roughly with what ECB officials might have expected (see SGH 5/31/17, “ECB: Contours of a Cautious Exit Plan”).  But the currency would clearly create issues, more unwanted downward pressure on inflation  if it were to accelerate further and keep going up and up from where it is now, at around 1.2000.

The limited verbal intervention by ECB officials has, however, to date been awkward – when they say something it rises anyways, and when they say nothing it rises because they did not address the Euro. They therefore are not commenting much formally, at least not yet, but the currency is a factor that is starting to matter, and so markets get informal background verbal intervention, such as through last month’s ECB minutes.

ECB officials also appreciate there is a material difference between now and May of 2014, when the Euro was at 1.4000 and Draghi verbally intervened to turn the trend around with huge success. At that time, verbal intervention was followed through with rate cuts.

This time around, ECB officials are aware that verbal intervention may not have lasting impact in that it will not be followed with rate cuts or increased bond purchases, but rather the opposite, the gradual slowing of the pace of accommodation (QE) next year when the current program runs out.

So beyond verbal interventions the question is does or will the strong Euro impact the actual taper/policy response for 2018 – a potential weight on inflation even though the causes for Euro rise are also positive, strong growth, etc.? The answer is it will, and has, already had an impact, at least on the margins.

For one, with inflation still stubbornly low, the decision and announcement on how to proceed with QE in 2018 will be delayed, deliberately, to October. Furthermore, the pace will be prudent, and likely to last through the year.

September, October, and Beyond

At next week’s meeting, the Governing Council will assign task groups to study alternative models for 2018 for bond purchases and perhaps (albeit unlikely) beyond. The concrete decision on which plan to pursue will not be made until the October 26 meeting. That is a time frame that is already is a bit slower and more deliberate than the early considerations this year of making a decision at this September meeting.

And furthermore, whichever plan the Governing Council chooses, ECB official agree that the new pace of bond purchase for 2018 will have to lower purchases prudently, in small steps, and over an extended period of time.

While that may or may not be dovish enough to stop the ascent of the mighty Euro, it is the appropriate course of action, with forecasts still requiring substantial accommodation, inflation still low, and potentially tweaked down at next week’s quarterly forecast revision. 1.2000 on the Euro is fine for the time, but the Euro should not be going up, ECB officials contend, all the time.

In choosing the parameters of QE for 2018, the Governing Council will nevertheless need to balance the economic imperative – and there is broad consensus for this – to be gradualist, with the real technical constraints it is facing in owning bonds beyond the self-imposed 33% band of issuer limits on sovereigns.

ECB officials are respectful of sensitivities around the German Constitutional Court in Karlsruhe, which referred some outstanding lawsuits on QE to the European Court of Justice this month, and will have little desire or incentive to change anything on the issuer limits that would needlessly create problems on that front. So the new plan will have to provide accommodation, convince markets, and avoid potential shortages down the road.

The options have not even been laid out yet, but is it possible in theory the ECB could do a step-down on bonds purchases, say from 60 to 40 billion Euros a month, keep it there (for six months), and then taper on a predictable monthly/per meeting basis, obviously always subject to change, to zero by the end of 2018.

Or the ECB could conversely taper gradually for six months or so, and then leave a tail amount of purchases, which it can then reassess in the middle of 2018.

Whatever the plan, ECB officials will from what we understand seek some security/predictability of purchases for a six-month period for 2018, and avoid creating speculation and making decisions at every meeting – after all, numbers don’t change so dramatically month to month, then reassess. Furthermore, options under consideration we believe will center around a program for the full year, 2018.

While Draghi, Chief Economist Praet, and other ECB leaders have clearly always tended towards the prudent side when it comes to managing the risk of removing accommodation prematurely or too quickly, to be fair there is more or less consensus on such gradualism for 2018. For example, even German Finance Minister Wolfgang Schaeuble in consistently calling for normalization of policy has been conceding it will be a process that has to be measured in pace. Likewise, Germany’s Bundesbank President Jens Weidmann.

Succession, and post-Draghi Speculation

On that note, while the ECB will steer clear of such politics, speculation over the succession for Mario Draghi, whose term expires in October 2019, has clearly started and will accelerate heading into 2018.

The press has focused almost entirely on Weidmann as Draghi’s potential successor, reflecting perhaps the lines of an informal political agreement from the early days of the inception of the central bank – although faded over time – to alternate the presidency between North and South, “French and German,” camps.

Weidmann, while a strong contender, has, however, raised some eyebrows with critics who contend (rightly or wrongly) the BUBA President has had a tendency to cater to the domestic German press, at times at the expense of the broader Eurozone message.

The succession is further complicated by the opening up of other key EU/Eurozone positions in 2019 – European Commission head, European Council President, and possibly the Chief Economist position within the ECB. That raises the political question of whether member states negotiate a big personnel package, as generally assumed, or seek an effort to depoliticize the ECB appointment by agreeing to that before the rest.

An earlier decision for ECB President would have the benefit of delinking it from national politics of the other appointment, but would create a serious problem in the announcement or even potential confirmation of a successor for Draghi well before his term ends, creating an awkward, unfair, and counterproductive lame duck problem for half a year.

And as far as candidates go, the ECB presidency is far from a lock for Weidmann. When the time comes, we expect there yet to be a push for the highly qualified Benoit Coeure, a natural candidate in the traditional tug of control between France and Germany for leadership, and in an effort from Paris and French President Emmanuel Macron to reassert some balance in the alliance that has drifted so heavily towards Germany over the last decade or so.

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