Monetary Policy - Implications Of ECB's Dovish Taper - JAN 2018

BMI View: The European Central Bank ' s tapering announcement in October points the way to a gradual exit from extraordinary accommodation, but we continue to believe that policy will remain very easy for years. Our core view remains that the ECB will continue expanding its balance sheet into 2019 and keep its benchmark interest rates on hold until 2020 , a policy mix that will keep the euro on the back foot against the US dollar.

At its October 26 meeting, the European Central Bank (ECB) kept rates on hold (deposit rate at -0.40%, main refinancing rate at 0.00%, marginal lending rate at 0.25%) and announced a reduction in the pace of its monthly net asset purchases from EUR60bn to EUR30bn, beginning in January 2018 and lasting through at least the end of September 2018. This was broadly in line with market expectations and our view that ECB asset purchases are likely to continue through the end of 2018, albeit at a slower pace.

To the extent that an announcement to slow asset purchases can be considered dovish, this one certainly was, with President Mario Draghi emphasising in the post-meeting press conference that the ECB stood ready to expand policy should inflation continue to run under the 2.0% target over the medium term. Our core views on eurozone monetary policy are largely unchanged by the announcement, though there are a few key takeaways that we emphasise.

The eurozone economy looks good...but not good enough : While the message out of the announcement was that the Governing Council was generally positive about economic developments in the eurozone in 2017, it was far from satisfied that its job is done. The ECB's inflation projections (with inflation in 2017, 2018, and 2019 of 1.5%, 1.2%, and 1.5%, respectively) underline its view that the eurozone recovery has not yet reached the point where, in Draghi's words, the improvement is 'self-sustaining' and no longer requires monetary accommodation. In our view, a range of factors, including political risk, structural economic weakness, and debt loads in the eurozone periphery, mean that easy monetary policy is likely to be the default stance for years to come.

Net asset purchases will continue into 2019: Our long-held core scenario was that the ECB would extend purchases through June 2018 at a EUR40bn pace, with a further extension meaning that buying would continue through the end of 2018 at least. The October announcement implies a similar scale of total purchases to our expectations (EUR270bn versus our EUR240bn, with the balance sheet already at EUR4.3trn in early October), but only further underlines that the ECB will continue to buy assets through the end of the year and probably into 2019.

Further To Run
Eurozone - ECB Assets As % of GDP, Quarterly
Source: ECB, BMI

Draghi took pains to emphasise that a large majority of the ECB Governing Council favoured open-ended purchases (this was one area in which policymakers at this meeting were not unanimous), and not a strict timeline for the programme's completion. Indeed, he made assurances that purchases are not going to suddenly stop, and that the Governing Council has not discussed an abrupt end. Again, this emphasises that purchases may slow past September 2018, but they are likely to continue for at least a few quarters thereafter. Not only this, but Draghi mentioned several times that the ECB regarded the size of the balance sheet itself as a major factor in monetary policy accommodation, with maintaining the stock itself implying billions of monthly purchases as maturing proceeds are reinvested. The ECB is likely to take a significant amount of time between stopping new purchases and rolling off its balance sheet, in our view.

No rate hike until balance sheet has steadied: The ECB may raise policy interest rates before stopping balance sheet reinvestment, but it will not hike until net asset purchases are over. In other words, rates are unlikely to rise until the nominal size of the ECB balance sheet flatlines. With the ECB emphasising this time and again, a one-off deposit rate hike in order to narrow the corridor between the depo and refinancing rates to a normal 25bps (it is currently 40bps) looks to be off the table until after the asset purchase programme is finished. Overall, while the deposit rate is likely to be hiked by 15bps before the other rates for this technical reason, we maintain our view that the first refinancing rate hike will come only in 2020, well after net asset purchases have finished.

Technical limits can be overcome: As the next year unfolds, there will be many questions as to the ECB's ability to continue purchasing some member states' government bonds (such as Germany's) without running afoul of technical limits such as issuer and capital key restrictions. Draghi said that the Governing Council did not discuss parameters or limits at the October meeting, but added that every time they are questioned on whether they will be able to carry out their purchase programme given limits, they give plenty of evidence that they can and will do it.

Fed-ECB Divergence To Grow
End-of-Year Policy Rates, %
US=Lower end of Fed funds range; Eurozone=Refi rate; f=BMI Forecast. Source: ECB, Federal Reserve, BMI
EUR has likely topped out for now: