ECB Meeting Will Likely Bring Fewer Purchases
There are different scenarios in which asset purchases by ECB could be scaled back next year. The pace could be significantly slower but with a longer extension.
On October 26, 2017, the European Central Bank (ECB) will make its decision regarding how to recalibrate its monetary policy parameters. The minutes of the last ECB meeting, in September, showed that there was a preliminary discussion of different scenarios in which asset purchases could be scaled back next year. Specifically, the pros and cons of a significantly slower pace of monthly purchases coupled with a longer extension, versus a faster pace and a shorter extension, were discussed.
Using some numbers that were floated by the media, the scenarios apparently included a 20 billion Euro pace for nine months or a 40 billion Euro pace for 6 months. Subsequent news reports suggested that consensus at the ECB's Governing Council appeared to be converging towards a nine-month extension and a significant reduction in monthly purchases.
A Longer Extension Would Do a Better Job
As Peter Praet, Chief Economist of the ECB, has argued recently, ultimately it is the amount of long-dated bonds that the ECB is buying that is relevant in order for markets to reprice the term premium, i.e., the risk premium required from investors to hold bonds with a longer duration. If this was the only thing that mattered, the ECB should probably go for the combination that has the largest absolute volume. However, besides the bond scarcities that need to be considered in order to make the extension of purchases credible for markets.
Another factor that impacts bond yields also plays an important role: market expectations of how short-term interest rates are likely to evolve over the coming years. ECB officials have repeatedly emphasized that the sequence of normalization steps—first end asset purchases, then start thinking about rate hikes—is unlikely to be changed. Therefore, a longer extension would do a better job of keeping market expectations of a first ECB rate hike low, and would also contain appreciation pressure on the euro versus the dollar.
First Important Step Forward
In terms of pushing out rate expectations, the ECB seems to view the additional three months of a longer extension as largely equivalent to a slightly higher total purchase volume in the case of a shorter QE extension. An added benefit of a longer period would be that the ECB gets more flexibility and credibility regarding its QE program; should economic data unexpectedly deteriorate, the ECB could—in a worst-case scenario—even react by temporarily raising (or extending) purchases again.
Regardless of the combination of duration versus pace of purchases that the ECB will ultimately opt for, the process of normalizing monetary policy will likely take a first important step forward—even though the ECB will do its best to downplay any perception that an automatic process has been set in motion. But if the Eurozone recovery continues with its current robustness, inflation should indeed trend higher in the coming quarters and thus justify a slow but steady withdrawal of monetary stimulus in the Eurozone—a process that will continue well beyond Mario Draghi's term as ECB President.