All it took was a few words from Mario Draghi to send the euro and governments’ borrowing costs soaring, much to the displeasure of the European Central Bank chief.
Mr Draghi’s claim in late June that “reflationary” forces had replaced deflationary ones was intended to provide reassurance that the eurozone’s economic recovery was on track. Instead, it led investors to believe that the bank was about to tighten its policy — a misunderstanding, the ECB later claimed.
The incident at the ECB’s annual forum in the Portuguese report of Sintra underlined markets’ jumpiness about an end to the extraordinary monetary policy put in place since the financial crisis.
As Mr Draghi prepares to make his first public comments since Sintra, the ECB is set to be tested again. One issue above all inspires nervousness: the fate of the bank’s €60bn a month quantitative easing programme.
“Orchestrating the entrance into the exit [from QE] is the challenge for Draghi,” said Carsten Brzeski, economist at ING-DiBa, as he discussed the ECB’s governing council meeting on Thursday.
“All central banks, especially the ECB, have made one of their goals to be predictable, to be able to steer markets, and not to surprise. But we’ve seen it’s very difficult to steer markets; especially bond markets.”
The governing council faces a balancing act between reducing QE because of stronger growth and recognising that markets remain jittery and inflation weak.
It is a challenge it shares with other top central banks, notably the US Federal Reserve, which also has a yet-to-be attained inflation target of about 2 per cent.
Figures published this week showed that eurozone inflation had slowed to 1.3 per cent in June, down from 1.4 per cent in May. Wage growth, an important bellwether of longer-term price pressures, remains weak, even in the region’s strongest economies.
Nevertheless, the ECB’s extraordinary monetary stimulus has helped the eurozone beat US growth rates this year, by easing borrowing conditions for governments, companies and households.
ECB figures on bank lending, published on Tuesday, showed that demand for most types of loans increased in the second quarter, while credit was granted on more favourable terms.
Some ECB officials are worried that, if mishandled, the process of reducing QE will push borrowing costs and the euro higher, choking the recovery.
One worrying precedent is the 2013 “taper tantrum”, when the dollar and Treasury yields soared after the Federal Reserve suggested that it would wind down US quantitative easing.
Peter Praet, the ECB’s chief economist and one of the council’s doves, has taken the unusual step of advising council members against saying too much in public to avoid panicking markets used to central bank stimulus.
At issue on Thursday is not a decision to rein in QE itself, but rather to tweak the ECB talking points to remove a commitment to boosting asset purchases if the economy takes a turn for the worse.
The ECB discussed scrapping such a reference at a meeting in Tallinn last month. If it went ahead with such a move this week, it would set the tone for cuts in monthly asset purchases in 2018, an issue many analysts expect the council to vote on at its next meeting on September 7.
“Our view is that they will take away the easing bias and begin to steer markets towards tapering next year,” said Michael Strobaek, global chief Investment officer of Credit Suisse. “There is a pressure from within the council to become more hawkish given the [positive] way the economic recovery is developing.”
One governing council member, Benoît Cœuré, has hinted that the bank could reduce QE in 2018 by following its playbook for this year, a prolongation of the programme but with smaller monthly purchases than before.
Mr Draghi himself has given few such clues as to how tapering might occur, just as Janet Yellen, his Federal Reserve counterpart, kept her monetary policy options open in Congressional testimony last week.
ECB hawks argue that keeping quiet now could store up more trouble for later. They say markets have long expected the central bank to slow the pace of its bond buying next year and should be able to digest the ECB’s withdrawal from the region’s debt markets.
But several analysts are far less sanguine as the ECB seeks to navigate uncharted waters.
“In the current set-up, when inflation remains below the 2 per cent target, it’s hard to see which indicators the ECB is following and which are given more priority than others,” said Mr Brzeski. “It’s hard to see how they can trigger this process without triggering a [market] tantrum.”