ECB: The Beginning of the End of QE

Published on January 10, 2018

There will be little of note on the policy agenda when the European Central Bank Governing Council meets in two weeks, on January 25, apart from an opportunity to take stock of the continued upbeat evolving economic conditions in the Eurozone.

*** Even so, the powerful six-member ECB Executive Board appears to be inching closer to the position of some National Central Bank governors, spearheaded by Bundesbank President Jens Weidmann, who are calling for an end to bond purchases when the current 30 billion Euro per month Asset Purchase Program is up for review at the end of September. And despite some analysis to the contrary, the latest, perhaps slightly disappointing, December Eurozone inflation prints are still well within forecasts, and will not move the needle on that position either way. ***

*** We expect the other exit option when the time comes for consideration to be for a more cautious, ten billion Euro per month tapering down of purchases from September that would  see the program end at a natural, December 31 date. But our expectations are for the Governing Council consensus to gradually coalesce towards a hard September stop. A truly unexpected, material undershoot of the forecast would be needed to price in any realistic consideration on the other side of an extension of the QE program beyond 2018. ***

*** On the rates front, a potentially earlier than expected end to the QE program will inevitably raise questions over whether and how the ECB may amend its commitment to keep rates “at present level for an extended period of time, and well past the horizon of the net asset purchases.” We understand that language, and commitment on rates, will not change anytime soon. Draghi and the Governing Council at large, including the so-called hawks, are not only likely to remain committed to keeping the front-end solidly anchored, but they would not mind a bit of a steepening in the yield curve as the recovery becomes more entrenched. ***

None of this will be up for discussion at the upcoming meeting, however, which will instead be a generally low-key affair; if anything, Draghi is said to be somewhat displeased at some of the public commentary from ECB officials around exit preferences swirling around of late.

That QE debate will pan out through the middle of the year, and in anticipation of a shift in September.

The Board and Market Dynamics

With the very important caveat that the new year has only just begun, three of the six Executive Board members of the ECB — Benoit Coeure, Sabine Lautenschlaeger, and Yves Mersch — appear now to be open, if not outright sympathetic, to the option of a hard stop to bond purchases after September, assuming the data holds in as broadly expected.

The other half of the Board, and an important half it is — Chief Economist Peter Praet, Vice President Vitor Constancio, and President Mario Draghi — still remain more cautious, and we believe would continue at least for now to lean towards the option of tapering purchases from thirty to zero over the last quarter of 2018. (Constancio’s term is set to expire in April of this year, and the position is expected to be filled by a candidate from Spain).

Furthermore, Draghi is said to actively shun any premature discussion of exit options in order to retain maximum policy flexibility for as long as needed. That caution extends to a reticence even to discuss second half 2018 decisions in close quarters, as these also could always be subject to leaks.

But if economic conditions indeed allow the ECB a smooth exit this year, the choice between September and December will be a tactical one, increasingly driven by market expectations, or more precisely, by the ECB comfort level when the time comes that markets will be ready for the move.

The data, of course, will have to lead the way, and it looks like it will.

Growth Upgrades Down the Line

On the data front, Eurozone growth, employment, manufacturing, expectations, and orders numbers have all remained remarkably solid, with continued strength in the “hard” numbers, and a little pullback if anything from historic highs on some of the “soft,” survey data. Perhaps just as importantly to the ECB, these solid numbers also continue to be broad-based, across industries, sectors, and the Eurozone as a whole.

As to communications, looking ahead to the upcoming ECB meeting on January 25, there will have been little in the way of data to materially change the already upbeat overall outlook and tone that characterized Draghi’s presser and economic assessment in December. But that narrative is expected to be upgraded further over the course of the year.

Not to be forgotten, that all assumes, as ECB officials hopefully expect, by summer the political environment will have cleared up some of the “shadows” that do hang over the Eurozone.

Specifically, there should be some resolution by then certainly to what have been to date very challenging coalition negotiations in Germany, and of the potential risks posed by Italian elections in March (see SGH 11/16/17, “Germany: Merkel’s Last Play” and 12/19/17, “Italy Elections: A Blazing Berlusconi Comeback”).

Suppressed Headline, but Rising Core

It is the inflation data, however, that remains the main source of frustration to the ECB. And the December Eurozone CPI data for one may have disappointed a bit. But with patience, and a continued accommodative monetary policy, ECB officials continue to expect inflation numbers to stabilize, and push slowly higher.

More specifically, expectations are that headline inflation in the near term may actually be pressured by year-on-year energy price base effects. The annualized headline rate did in fact nudge down a bit in December, from 1.5% to 1.4%.

But it will be the core, “underlying” rate, which has seriously lagged to date at around 1%, that is now expected to converge closer to the headline rate.

A good part of the confidence on core inflation stems from rising expectations for a material, even if modest, uptick now in wages. Those include for the first time perhaps in a generation of traders a renewed keen focus again on large scale union wage negotiations, starting with those currently underway between Germany’s IG Metall union and its employers.

The German Juggernaut

With the German labor market at historically tight levels, the scales are expected to finally tip back towards labor in these, and other similar negotiations. Indeed, employers in Germany are finding that non-financial perks they have built to date, such as kindergartens and gymnasiums for employees, now only go so far, and that they will have to concede some old-fashioned wage increases as well.

To underscore further the tightness in German labor markets, the Bundesbank reports that the largest wave of migrants into the country has been absorbed easily into the economy. By convention, German statistics do not include migrants into the labor pool for two years after their entry into the country while they undergo language and employment training. The crest of these migrants is rolling into the labor pool statistics now.

These migrants do typically fill lower paying positions, and the sheer number being added to the work force may exert some downside pressure on wage growth in the very near term. But looking through that, this major source of entrants into the labor pool is set to shrink, and by a lot, given the dramatic fall in migration after 2015.

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