QE In The Eurozone: Lower For Longer Means Lower For Longer

Financial markets’ attention has understandably been focused this past week on the U.S. presidential inauguration ceremony and the first economic decisions that could be announced by the new administration.

Meanwhile, the first European Central Bank (ECB) governing council meeting of 2017 that took place on Jan. 19 appeared uneventful at first sight. During the ensuing press conference, ECB President Mario Draghi essentially reiterated the key points made in December: the extension of the bank’s quantitative easing (QE) program beyond March at a slower pace (€60 billion a month of purchases, from €80 billion previously). What this means-–although he did not exactly say that–is that lower for longer means lower for longer, just like Brexit means Brexit. The bank is saving fuel in anticipation of having a longer road to drive. But the ride isn’t likely to be smooth as rising divergences appear among eurozone members.

The Rise In Inflation Is Uneven
For so long it looked like it would never happen again, and yet it did: headline inflation is back in the eurozone. In December prices were up 1.1% in the monetary union (see chart 1a), lifted by much higher oil prices and the weak euro exchange rate. Denominated in euros, Brent prices were up 110% in the 12 months to Jan. 19, 2017. This mini oil shock combined with a general improvement in economic activity across the region is pushing retail prices up. But the ECB warned that it is way too early to declare victory on the inflation front. This is because core inflation, the measure that excludes volatile items such as energy and food, remains much lower. But the devil, as always, is in the detail. It’s true that the latest read for core inflation isn’t signaling any meaningful acceleration. But there is one exception–Germany–where all measures are consistently up.

The eurozone’s largest economy is cruising at full capacity and close to full employment. No other economy can really claim to be in the same condition. The German ZEW indicator of economic sentiment improved in January and returned to pre-Brexit levels, while the assessment of the current situation surged to its highest level in five years. This adds to positive hard data recently released, and shows that sentiment in Germany remains high.
We expect this gap between Germany and its main eurozone partners to prevail throughout 2017, with both headline and core inflation outperforming. We forecast headline and core inflation to average about 1.6% this year.
Unsurprisingly, voices in Germany are asking for a tightening in the ECB’s monetary policy to contain inflation pressures. The argument is that half of the increase in wages implemented at present is governed by collective bargaining agreements concluded in 2016, i.e. before inflation started to accelerate. Those agreements set out a rise of slightly over 2%, implying lower growth in real terms. At the same time, new bargaining rounds are taking place, especially in the public sector, which could be influenced by the recent acceleration in inflation, with the risk of creating second round effects that could trigger an inflation spiral.
Of course such concerns look premature. The rise in German inflation measures is recent, and setting aside the influence of higher oil prices, is a reflection of a strong economy having recovered well from the great financial crisis.
But let’s not forget that German savers in Germany have for some time felt the pinch of very low interest rates. If wage earners in turn also started to feel penalized, the pressure on the German political leadership–in a year of elections–would build up, making the ECB’s monetary policy the subject of elevated criticism.

The Time For Tapering Hasn’t Arrived (Yet)
During his press conference, Mario Draghi stressed again that the definition of price stability and the inflation target applies to the euro area as a whole, suggesting that individual country divergences cannot be addressed by the central bank. As often explained by ECB officials, the bank does not have 19 monetary policies, but only one. That said, the governing council had also to address an immediate and rather new concern: since the U.S. presidential elections global bond yields have been on the rise. The contagion to eurozone rates has so far been limited, in part because of the presence of the central banks on the markets with its asset purchase program. But if markets were to start assuming that the central bank is heading to end QE, bond spreads would widen, although economic conditions in the eurozone do not yet justify such hikes. Indeed, the latest monetary statistics released for the month of November reveal a gradual but slow improvement in lending and credit conditions. New lending to households is on a steep upward trend, thanks especially to strong demand for housing loans, but lending to non-financial corporations remains weaker.

Addressing Scarcity Issues
Another market concern the central bank needs to focus on relates to the amount of available assets it will be able to purchase in the coming quarters. Minutes from last month’s ECB meeting show that the decision to trim monthly purchases from March was influenced by concerns over availability of assets. On the one hand, northern national central banks (Germany, The Netherlands, and Finland) have become reluctant to buy large volumes of bonds trading below the negative deposit rate, therefore having to post ex ante losses. In response, the governing council decided this month that “no purchases below the deposit facility rate will be conducted under the third covered bond purchase program, the asset-backed securities purchase program, or the corporate sector purchase program”. In addition, “with regard to the public sector purchase program, for each [national central bank], priority will be given to purchases of assets with yields above the deposit rate”. More flexibility is therefore granted to each national central bank.
But there’s a second issue pertaining to the credibility of the ECB’s QE program: how will the reduction in the overall pace of purchases translate to sovereign and corporate bonds purchase? In other words, will the reduction be proportional across asset classes? So far, the ECB has bought €54 billion of corporate bonds against €1.5 trillion of total asset holdings. The ECB purchases since March 2015 have contributed to the maturation and deepening of the euro bond markets. But compared to the U.S. disintermediation, the eurozone is still far behind, with banks still providing the best part of overall funding to the euro area economy. The recent decline in the share of bank loans did not entirely benefit bond markets (see chart 2): indeed non-bank funding (also called “shadow banking”) benefitted as well.

The relatively narrow corporate bond sector implies that pricing in this sector has become very dependent on the actions of the central bank. Besides, if economic conditions were to deteriorate again, making additional QE necessary, the lack of eligible assets to buy could force the central bank to extend its purchase program to new asset classes, such as equities. We do not see this scenario as likely at this stage, but we do anticipate, despite increased pressures coming from Germany, a very gradual and cautious reduction of the purchases in the second half of this year to perhaps €40 billion a month, with an additional cut in the first half of 2018. The magnitude of this reduction will depend on the global credit conditions prevailing at the time.

Jean-Michel Six – Chief Economist – Standard & Poor’s