Like other central banks, the ECB is seeking to better understand unusual economic dynamics that complicate both policy assessment and policy responses. By Mohamed A. El-Erian
When the Governing Council of the European Central Bank meets on Thursday, it will continue to prepare markets for the start of its long process of normalizing its unconventional monetary policy. But the central bank is unlikely to announce the specific details that markets and others are looking for, and not just because of the complexity of the task at hand. Central bankers will also seek to keep their policy options wide open as they weigh competing and, in some cases, puzzling and uncertain, policy considerations, even as they think about how best to sequence their measures with those of other systemically important central banks, particularly the Federal Reserve.
As it presents its latest economic assessment and policy findings, the ECB is likely to support the consensus view in the marketplace that, as of January 2018, it will be reducing the pace of monthly asset purchases. This belongs in the context of a gradual phasing out of the program, combined with rate hikes and, much further down the road, an outright contraction of a balance sheet that has ballooned as a result of the large-scale asset purchase program. What the central bank is unlikely to do, however, is provide the exact details of this process, including the lower scale of purchases for the first half of 2018, preferring instead to keep that for a Governing Council meeting later this year.
The complexity of the upcoming taper policy pivot will be one factor behind the likely delay. But it won’t be the only one. Indeed, it may not be the major reason.
Like other central banks, the ECB is seeking to better understand unusual economic dynamics that complicate both policy assessment and policy responses. For example, economic growth has picked up around the euro zone, and forward-looking indicators appear generally encouraging; moreover, perceptions of regional political risks have declined. Yet, inflation remains stubbornly low. Indeed, as much as central bankers will it away, they haven’t gotten rid of a lowflation demon that can threaten the region again with growth-destroying deflation.
That is not the ECB’s only headache. There is also a trade-off between currency and financial stability.
Since the start of the year, and reflecting in part the euro zone’s improved economic performance, the euro’s trade-weighted exchange rate has appreciated significantly. Over time, this is likely to serve as a direct headwind to growth by making exports less competitive and imports cheaper, while also placing downward pressure on an inflation rate that, in the eyes of many central bankers, is already too low. But it also faces a dilemma shared by other central banks: If monetary policy stays loose for longer, the ECB may inadvertently encourage even more of the type of excessive risk-taking, particularly by non-banks, that could culminate in growth-destroying financial instability down the road.
As these issues extend beyond the euro zone, they also entail complicated cross-border interactions and feedback loops, especially when it comes to the sequencing of monetary policy normalization among systemically important central banks. Moreover, in recent weeks, markets have reduced expectations of the pace of future interest rate hikes in the US Reinforced by signals from officials there that the terminal rate for the fed funds rate has declined, the result has been even greater pressure for the euro to appreciate.
With all this in play, it is not surprising that the ECB is keen to retain as much policy flexibility as possible. Yet this is not a free good, particularly when it comes to market conditioning and responses.
In the environment of the last few years, markets have become very comfortable in interpreting the lack of official guidance on the policy normalization as a green light to increase financial bets on the continuation of a low volatility journey, delaying the important consideration of (and positioning for) the destination. This environment also emboldens markets to believe they can lead central banks, rather than be led by them. And there is nothing that short-term-oriented investors and traders like more than what they firmly believe are malleable central banks that remain committed to boosting asset prices and repressing financial volatility.
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