Things are going great in the eurozone. Economic growth is the strongest it’s been in a decade. The unemployment rate keeps falling and is now at the lowest since 2009. And consumers are the most upbeat they’ve been since 2001.
Sounds like a dream come true for a central bank that’s been fighting for years to shake off a devastating debt crisis and a financial meltdown. However, for the European Central Bank the rosy picture also comes with the difficult task of tightening monetary policy without strangling the region’s recovery. The solid data have already increased pressure to end the ECB’s ultraloose policies, setting the central bankers up for a lot of questions at its meeting on Thursday.
“If we came down from Mars and saw this fantastic growth in the eurozone—low-ish inflation, yes, but really, really strong growth—and financial conditions that are very loose, you might think rates might be 2%, even be 4%. But they are negative,” said Alan Higgins, chief investment officer at Coutts, at a recent event.
“We would say the current ECB policy is far too loose. But the issue the ECB have, is that they know if they reverse this, they could cause a surge in the euro,” he said.
Interest rates are currently at all-time lows in the eurozone, with the deposit rate—the rate the ECB pays on deposits parked with it overnight—at negative 0.4% and the refinancing rate—the ECB’s main lending rate—at 0%. On top of those super low rates, the ECB also buys €30 billion worth of bonds each month in an effort to boost inflation.
Some investors, like Higgins, argue that a recovering region like the euro area no longer requires emergency measures such as quantitative easing and subzero rates. A major concern is that the economy could get so hot the central bankers would have to tighten policy so fast it would kill the upswing. Another fear is that with rates this low, the bank essentially has exhausted its emergency tool kit in case of another, unexpected crisis.
So why hasn’t the ECB lifted rates yet? It’s really all down to inflation and a longstanding ECB pledge to keep rates at current levels for an extended period. Consumer prices grew only 1.4% in December, below the bank’s target of close, but below 2%. But it’s not like the policy makers aren’t aware of their conundrum. Minutes from the bank’s December meeting confirmed that the Governing Council is debating its exit strategy, signaling a hawkish change in forward guidance could come in “early” 2018.
Those minutes sent the euro EURUSD, -0.0484% flying and provided fertile ground for speculation on what will happen at the meeting on Thursday. Here are some of the questions traders are most eager to get answers to:
1. Will the ECB start to raise interest rates now?
Nope, it’s way too soon. Inflation is still too low to President Mario Draghi’s taste and in any case the ECB’s forward guidance stipulates that rates will remain at current levels “well past the horizon of our net asset purchases.”
2. When will QE end?
The asset purchases were cut from €60 billion a month in December to €30 billion starting in January. The QE program will run in its current form until the end of September this year, or longer if the Governing Council finds that inflation is still undesirably low.
But several council members have in recent weeks hinted that there’s no need to continue the bond buys when the economy is powering ahead in such excellent shape. The statement on Thursday may hold some cues on the ECB’s thinking on this matter, but most analysts say it’s unlikely they’ll tweak their forward guidance quite yet. Any changes are more likely to come in March, when the new staff forecasts on inflation are out.
J.P. Morgan last week said it expects QE to come to a full stop in September, with the first rate increase following in March 2019.
3. What’s the outlook for inflation?
Price stability is the ECB’s sole mandate, but inflation is the only missing piece in the eurozone’s recovery. Falling to 1.4% in December, it remains below the central bank’s target of near but just below 2% and gives policy makers no reason to speed up the exit from loose monetary policy.
However, over the last month oil prices have jumped around 10% and wage negotiations in Germany look set to give German salaries a boost. Both could help lift inflation and strengthen the hawk’s argument for a rate rise.
There is a snake in inflation paradise though—the rising euro EURUSD, -0.0484%As consumer prices pick up pace, markets start to price in a rate increase, which in turn pushes up the euro. A stronger euro can weigh on inflation and halt the recovery as it’s likely to hit exports and make products more expensive for foreign buyers.
The euro is trading around a three-year high against the dollar at $1.2415, having risen more than 5% in the past three months.
4. What will the ECB do about the strong euro?
Draghi always takes pains to emphasize that the ECB doesn’t target a euro exchange rate, but policy makers are still very mindful of the risk from the currency markets. That means that after the recent rally in the shared currency, the bank is likely to address the euro strength at Thursday’s meeting and potentially succeed in talking it down.
In recent days, several ECB speakers have expressed concerns about the currency strength and nothing suggests Draghi will strike a different tone.
Economists at Daiwa Capital Markets expect Draghi to repeat the wording from the September meeting, that “recent volatility in the exchange rate represents a source of uncertainty which requires monitoring with regard to its possible implications for the medium-term outlook for price stability.”
5. What would be a dovish or hawkish surprise?
A dovish surprise could come from Draghi indicating that the ECB is likely to extend the bond purchases beyond September. That would probably push rate increase expectations further into the future and put an end to the euro euphoria.
On the on contrary, a hawkish surprise would constitute a change to the forward guidance or a definite announcement to halt the QE program altogether in September. Expect the euro to rally if the policy makers remove the “well past” from their rate outlook or the “or beyond” in their QE time frame.
The paragraphs read like this in the December statement:
• “We continue to expect [key ECB interest rates] to remain at their present levels for an extended period of time, and well past the horizon of our net asset purchases.”
• “We intend to continue to make net asset purchases under the asset purchase program (APP), at a monthly pace of €30 billion, until the end of September 2018, or beyond, if necessary, and in any case until the Governing Council sees a sustained adjustment in the path of inflation consistent with its inflation aim.”