Fly on the wings of doves
In a major victory for ECB’s dovish camp, the European central bank decided today to extend the bond purchase program until the end of September 2018, at a reduced pace of EUR30 billion per month. Moreover, the ECB kept the dovish wording in the press release promising to extend QE further if needed – and to keep interest rates at present levels well past the horizon of the net asset purchases. The decision was not unanimous, but favored by a large majority. It was – unsurprisingly – whether to keep the program open ended that caused disagreement.
Following in the footsteps of the Federal Reserve, ECB also announced that principal payments from maturing securities will be reinvested for an extended period of time after the end of its net asset purchases. Hence, the portfolio of assets will not decline until ECB actively decides so. Not surprisingly, the euro weakened a bit against the dollar.
What if conditions become more favorable?
By pre-committing to keep the program running for another eleven months, the decision on what to do next has been postponed. In the coming months, focus will be on developments in the US – both fiscal and with regard to the nominations to the Federal Reserve Board. Both could solidify the continued normalization of US monetary policy. However, if the European recovery continues at current pace, Draghi will increasingly face one of today’s most relevant question: “What will the ECB do, if conditions become more favorable?”. Draghi deflected on this, but he will not be able to do so, if economic growth and job creation continues at the current pace.
The euro area added 2.5 million jobs over the past year – much more than in the US. While unemployment is elevated at 9.1%, it is also declining sharply, and confidence is at or close to all-time high. The Commission’s ESI-index current points towards 3.7% annually, and yesterday’s German Ifo-index show strength in both manufacturing and construction. Today’s bank lending survey show continued improvement in financial conditions and rising loan demand.
There are signs globally of an upturn in corporate investment, which should disproportionately benefit the euro area in light of its prominent investment-goods sector. Rising investment in technology and machinery should boost productivity growth, which is good for longer-term growth – but also a damper on inflation. There are few signs that a tightening labor market is causing upward pressure on wages, and increased business investment should allow for substitution of labor, if wage pressures were to materialize. However, the moderate 2.5% wage growth in Germany – by all measures Europe’s tightest labor market – is a perfect example of how global competition in labor and product markets as well as free movement of capital have upset the prevailing economic structures and reduced pricing power. The ECB so far has failed to recognize this “mystery”.
Rising tide lifts all ships
At today’s press conference, Draghi repeatedly pointed to the differences between the US and the euro area as reason for the increasing divergence in monetary policy. However, this is also becoming a strained argument. When the US economy turned around from 2009, the euro area at first followed – only to drown in the euro crisis in 2012. Euro area growth actually reached 3% in 2011. ECB’s monetary policy has traditionally followed Federal Reserve’s with a lag of nine months (and a correlation coefficient of 0.91). It is the period between 2012 and 2015 that is abnormal in the global growth cycle.
While domestic factors remain more fragile in the euro area and ample monetary support is needed, the discussion is likely to shift in a more hawkish direction in 2018. Like the Federal Reserve, ECB could introduce a symmetric commitment (do more if worse, less if better). I also doubt that the period between the end of QE and moving the deposit rate out of negative territory will be very long. The wording on this could also change after new year.
In sum, Draghi has bought himself time today and the euro could weaken further to 1.15 against the dollar before end-2017. However, the current strategy merely amounts to postponing the inevitable. If monetary policy is kept too easy for too long with the associated buildup of imbalances, the handover to the real economy at a later stage could become really messy. I expect ECB has made significant progress in eliminating negative interest rates before end-2018, but this is not what markets will expect for now.