ECB treads warily to avoid taper tantrum

An economic recovery in Europe was supposed to make life easier for the European Central Bank. Instead, it has given officials in Frankfurt a problem as they prepare to decide whether to scale back the bank’s monthly bond purchases under its landmark quantitative easing programme.

The ECB is set for its most important meeting in months on Thursday when its governing council will finally put an end to a saga that has dragged on since the summer: outlining the shape of the third phase of QE. Mario Draghi, ECB president, believes the economy is now strong enough for the bank to at least consider cutting back on the amount of bonds it stockpiles each month, from the €80bn it has bought since the spring. The programme runs until March.

Mr Draghi told Spanish newspaper El País last week that his bank could tinker with “the amount of monthly purchases or the length of time over which they take place”. Analysts have interpreted those remarks to mean the bank’s governing council will be presented with a choice between continuing to buy €80bn of bonds monthly until September, or purchasing €60bn a month for longer, until December 2017.

Both options will mean the ECB eventually ends up owning between €2.2tn and €2.4tn worth of mostly government debt. But, with investors’ nerves frayed by political uncertainty, it is not only the size of the stockpile that matters.

Any suggestion that the ECB is heading for the exit and tapering its purchases could worsen the recent sell-off in government bond markets, reversing what the ECB has achieved since the eurozone’s central bankers began bond buying in March 2015. Borrowing costs have already been rising since Donald’s Trump’s US election win. A further jump in yields for the bonds of riskier governments such as Italy’s would undo the success that the QE programme has had in lowering borrowing costs throughout the region, not just in the eurozone’s most prosperous corners.

It would have echoes of the “taper tantrum” when rates spiked after the US Federal Reserve signalled it would begin to wind down the bond purchases it was making as part of its QE programme. The Fed was eventually forced to prolong its buying.

Favourable news on the eurozone’s economic recovery, which has withstood the immediate aftermath of both the UK Brexit vote shock and Mr Trump’s election, has allowed the ECB to take its time to decide what comes next.

Eurozone unemployment has finally inched into single figures; inflation, while still way below the ECB’s target of just under 2 per cent, has risen slightly; and surveys suggest growth is now at its strongest level this year.

Officials here also know that withdrawing some of the support will win the bank favour in Berlin, where QE is notoriously unpopular.

If the bank chooses to ignore German antipathy, it may risk a credit bubble by pumping too much easy money into the financial system when the economy no longer needs so much support. If it begins to unwind QE, it takes the chance that investors react badly and growth is stunted.

Frederik Ducrozet, economist at Pictet, said: “There is a strong economic case to reduce the pace of asset purchases. But I don’t know if they can do it at this stage. Markets are nervous because of the political environment, and if the ECB signals anything that looks like tapering it will result in tighter monetary conditions.”

Mr Ducrozet added: “When in doubt, the ECB should play it safe. QE is finally working in almost all of the directions and on all the transmission channels from markets to the rest of the economy. Do you want to jeopardise this now?”

Richard Barwell, economist at BNP Paribas Investment Partners, believes a decision to slow the pace would also reflect the political climate.

Challenges to central banks’ independence have accompanied the rise of nationalism. While the threat is more serious in the US and the UK, Germany’s economic and political establishment has repeatedly claimed that the bond purchases have stopped countries such as Italy fixing their economies.

“Markets are questioning whether the wings of the world’s two most powerful central banks will be clipped, their independence compromised by political forces but in opposite directions,” Mr Barwell said. “The Federal Reserve may be obliged to look the other way and let the economy run hot despite rising inflation. Irrational fears that low interest rates are delaying structural reforms may lead the ECB to pull back and let the eurozone slide into a disinflationary deep freeze.”

Both Mr Ducrozet and Mr Barwell expect the ECB to continue buying €80bn of bonds monthly for another six months, though Mr Barwell added: “I hope they will do more than that. I fear they’ll do less.”