QE extension risks reopening ECB rifts

Posted on September 7, 2016

German central bank announces 3.2-billion-euro profit for 2015 ...epaselect epa05178023 Jens Weidmann, President of the German Federal Bank, walks to the balance sheet press conference in the Federal Bank guest house in Frankfurt am Main, Germany, 24 February 2016. The German Federal Bank, the Bundesbank, announced profits of 3.2 billion euros in 2015, despite low interest rates. EPA/ARNE DEDERT©EPA

With the eurozone facing lacklustre growth, stubbornly low inflation and political uncertainty, most economists confidently expect the European Central Bank to keep buying billions of euros in bonds each month until well into next year. But many of those same economists also believe that the ECB is not ready to take such a decision quite yet. Instead, the consensus view is that when the governing council meets on Thursday it will shrink from any firm commitment to prolong its landmark quantitative easing programme beyond March 2017.

    The contrast between what the central bank is eventually expected to do and what it is thought likely to announce this week underlines the often fractious, and occasionally dysfunctional, way in which monetary policy works in the single currency area of 19 member states.

    If the ECB is to continue its large scale asset purchases beyond March it must drop or soften self-imposed limits that restrict the bonds it can buy; otherwise it will faces a scarcity of eligible debt.

    But altering those rules could revive a spat between the council’s hawks — notably Jens Weidmann, head of the Bundesbank — and the ECB’s top officials, led by Mario Draghi, president, who have backed QE to boost the eurozone’s economy.

    “At some point you start running up against the limits of your programme,” Richard Barwell, economist at BNP Paribas Investment Partners. “And changing the programme involves a difficult discussion.” He adds that while next to no-one expects the bank to stop its €80bn a month asset purchases as soon as March, “the ECB may not announce an extension yet because of the internal politics.”

    The sheer scale of the QE programme is beyond doubt. As of the beginning of this month, the ECB had spent €1trn on government bonds. Its efficacy is a different matter.

    At 0.2 per cent inflation remains well below the ECB target of just under 2 per cent and could well stay below that level until 2018 at least. Economists fear that a new set of ECB forecasts to be unveiled on Thursday will show as much.

    Chart: ECB asset purchase programme

    “Against [the backdrop of the ECB’s staff downgrading their inflation projections], the case for doing more is strong at Thursday’s meeting,” said Greg Fuzesi, economist at JP Morgan. “And yet there is no sign that any action will be taken.”

    Public opinion in Germany and elsewhere often views QE as a bailout by the backdoor for weaker EU states, while some economists have long questioned whether such am unorthodox policy is the right prescription for the eurozone’s lacklustre economic recovery. But many others think that an ECB promise to keep buying bonds in big quantities for much of next year will soothe fears over persistently low inflation and the long-term health of the economy.

    So far, the ECB has said only that it will maintain the purchases of €80bn a month until “at least” next March.

    With bond shortages likely to emerge early in the new year in Germany, where the Bundesbank must find around €10bn of bonds to buy each month, the ECB will have to come to some decision on the design of the programme by December.

    The most vocal opponents to softening the rules are the governing council’s German contingent, who are keenly aware of the drawbacks of the various possible alterations to QE.

    Getting rid of the minus 0.4 per cent floor on bond purchases, which prohibits policymakers from purchasing the most expensive sovereign debt, would expose the eurozone’s central banks to heavy losses. The alternative of scrapping the rule that bond purchases should reflect the size of a member state’s economy would open the way to buying more bonds from the most indebted countries, such as Italy, and could provoke much criticism in Germany.

    Chart: Eurozone GDP growth and inflation

    But German officials are far from alone in their reluctance to extend QE. Other policymakers closer to the centre of the council, such as Banque de France governor François Villeroy de Galhau, also support the ECB holding off from such a step — at least for now.

    Many ECB officials maintain the hope that other actors will relieve the bank of the need to doubling down on QE. Reflecting Mr Draghi’s own frequently expressed wish, Benoît Cœuré, a board member, has called on governments to do more to boost growth.

    But with inflation still in the doldrums and the end of the year fast approaching, the ECB may find that the divisive debate over QE can only be delayed just a few months longer.

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