By Economic Strategist, Hottinger Investment Management
Until last week, it seemed that the slowing European economy was apparent to everyone except the officials at the European Central Bank (ECB). Autumn passed and meeting after meeting of the ECB’s governing council yielded conclusions that had become almost platitudinous. Quantitative Easing (QE) was coming to an end; core inflation would continue to rise; unemployment would keep trending downwards and the slowdown in European growth was merely a reversion to a long-term, demographically determined trend rate.
With many countries having experienced weak or even negative economic growth in the third quarter and few indications that this will be short-lived, policymakers at the ECB have started to change their tune. The Bank has downgraded growth and short-term inflation forecasts in line with investor expectations (see chart below) and while QE will still end this month, the latest policy guidance from outgoing president Mario Draghi was more dovish. In his monthly press conference last week, following a meeting of the ECB’s Governing Council, Draghi highlighted a risk environment that is “moving to the downside”, with rising protectionism, emerging-market stresses and prolonged financial-market volatility bearing down on economic activity.
Analogous to the falling expectations for inflation, expectations for short-term interest rates in December 2019 have fallen throughout this year (see chart below) and now imply that the first rate rise from the ECB is now more likely to arrive in the first quarter of 2020 rather than in the second half of next year.
Draghi seemed to imply that the Bank is not dogmatically wedded to a 2019 rate hike; however, he did suggest that investors who have now put back their expectations for a rate rise into 2020 – after he will have left the Bank – could pave the way for an earlier tightening than that. The idea is that investors – by pricing in later rate hikes – make financial conditions today easier. This, apparently, could not only offset the weakening economic environment but stimulate the economy sufficiently that official interest rate rises in 2019 do indeed become necessary. It’s a tenuous argument from a Bank that has a penchant for optimistic predictions and a President who is keen to secure his legacy.
While the controversial QE policy is ending for now, Draghi did mention that the option to restart it remains, and the Bank will extend the period over which it reinvests maturing debt from one year to three years; 200 billion euros of bonds mature next year. This betrays the broader likelihood that an extended ECB balance sheet and the policy of QE are here to stay, as is the sizeable stake that the Bank has in the public debt of Italy and France.
Enter the politics of the ECB and QE
One controversial aspect of the Eurosystem will change at the beginning of 2019 when the ECB will make changes to its capital key schedule. Capital key is a weighting schedule that assigns proportions of its bond buying programme across the various member states according to the size of their economy and population. The table below shows the schedule that has existed since January 2015 and the changes the Bank will make next month.
The table shows that the shares of ECB bond buying (or, more accurately, reinvestment of maturing bonds) allotted to countries such as Germany, France, Austria and the Netherlands have increased, while those allotted to countries such as Italy, Greece, Portugal and Spain have fallen. This is problematic for general macroeconomic reasons and specific political, market and technical reasons pertaining to this period.
In the first instance, the policy is ‘pro-cyclical’; it exacerbates the strength of economies that are doing well and the weakness of one that are doing poorly. It therefore proposes that the Bank buy more bonds from countries whose economies are growing faster (which until recently included all those countries in the first group), easing financial conditions and lowering bond yields for them. It correspondingly proposes that the Bank buy fewer bonds from countries whose economies are struggling, such as Italy and Greece, tightening financial conditions and raising interest rates and bond yields.
In other words, the policy compounds a founding problem of the euro area that it somehow has to implement a single monetary policy that is suitable for 19 different national economies. Using the capital key schedule intelligently could serve that objective, but it would mean doing precisely the opposite of what is planned next year. The ECB should be buying relatively more Italian and Greek bonds and relatively fewer German and Dutch bonds in what would amount to a counter-cyclical policy.
The new capital key assumptions could inflame existing political and market tensions within the Eurozone. Reallocating ECB investments away from Italy, especially at a time when political uncertainty has led to elevated Italian BTP yields, could push funding costs of the Italian state to an unsustainable level. Analysts think yields of 5% would make servicing Italian debts much more challenging as the state reissues maturing debt. It could also aggravate the Italian government’s sense of grievance over its treatment by Brussels and make agreement over the 2019 budget harder to achieve.
The technical issues with the new pro-cyclical capital key centre around the fact that it proposes buying more bonds from surplus-generating countries that by implication do not have net new marketable bonds to offer. This would mean the ECB owning a greater share of these countries’ public debt as redemptions are rolled over. Such a development rubs up against political economy concerns, not least from Germany, over the legitimacy not just of the ECB’s operations but also the ECB’s increasing ownership of German sovereign debt.
In summary, the ECB will need to act adroitly to exit smoothly from its QE programme. Deteriorating global economic conditions suggest moves to tighten monetary conditions by either shrinking balance sheets or raising interest rates are premature. Further, the political reluctance of some surplus countries to continue QE, particularly after the term of progressive ECB President Mario Draghi ends, will create difficulties for the Bank to restart a similar programme of monetary expansion should conditions worsen further.
At some point, both the European political establishment and the ECB will need to come to terms with the fact that the central bank’s involvement with the public debt is likely to become necessarily permanent, and that the actions of the ECB will therefore need to come under broader democratic scrutiny. As such, an agreement on how the Bank should run would have to have support from both surplus and deficit countries within the Eurozone.
In the meantime, the way the ECB handles its decision to maintain its balance sheet, especially through its policy on capital key, will in large part determine the success of the European economy in 2019. In addition, we should keep a close eye on the process by which the ECB chooses Draghi’s successor. A sharp reversal of the Bank’s philosophical outlook to the Germanic and pre-Draghi low-inflationary model may come at a bad time – economically and politically – for the region.
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