Mario Draghi has been wrestling with a €2tn issue throughout this year — how to rein in the European Central Bank’s quantitative easing programme without alarming the markets and slowing down the eurozone’s recovery.
Now, as the hour of truth looms for the €60bn-a-month asset purchase scheme — due to be discussed at Thursday’s ECB meeting ahead of a likely decision in October — attention is shifting elsewhere: notably, to interest rates.
“The ECB thinking into next year could be that what matters more for the euro is not the size [of] QE, but keeping . . . interest rate expectations anchored for as long as possible,” said Marchel Alexandrovich, economist at Jefferies International, an investment bank.
QE remains an intensely polemical topic as the ECB president can attest. Germany has always been uneasy about the bond-buying programme, while eurozone countries with lower levels of growth are much more enthusiastic about its impact on reducing borrowing costs.
Wolfgang Schäuble, Germany’s finance minister, called on Wednesday for the ECB to ditch such extraordinary crisis measures because of the strength of the eurozone recovery. “Unusual monetary policy implies it is not usual or normal — we should get back to a normal monetary policy,” he said. “We have come back to a normal situation much quicker than people thought.”
But, insofar as they refer to QE, Mr Schäuble’s remarks are in line with the consensus, which is increasingly confident of a decision next month to scale back asset purchases from January, so that the scheme can wind down next year.
Since the ECB risks running out of eligible assets if it continues purchases at their current pace and Mr Draghi has declared several times that his bank has vanquished the threat of deflation, much of the rationale for QE has gone.
That is not the case, the ECB argues, for interest rates.
At 1.5 per cent compared with a target of just below 2 per cent, inflation is still weak, partly because of the strong euro. Core inflation is even more feeble, at 1.2 per cent.
There is broad agreement within the ECB’s governing council that any decision to increase rates from their current record lows could risk throttling the recovery, despite demand for higher rates from Germany and elsewhere.
At present, the main refinancing rate is zero while the deposit rate paid by banks is minus 0.4 per cent.
Despite the healthy eurozone recovery that brought growth to 2.1 per cent for the year to June, expectations of a rate rise in the medium term have dived in recent months — particularly since a conference speech Mr Draghi gave in Sintra in June.
The initial aftermath of that speech, in which the ECB president said “deflationary forces have been replaced by reflationary ones”, was a jump in the euro, as investors judged that there would be less reason in the near future to keep interest rates low.
But ECB officials hastened to say that Mr Draghi had been misunderstood, and his speech also argued that policy “needs to be persistent” because inflationary pressures were “not yet durable and self-sustaining”.
Since then, markets for futures contracts indicate that investors have gone from pricing in a 90 per cent chance of a rate rise by the end of 2018 to a 40 per cent chance — the lowest probability on record.
One central bank official close to the deliberations said the adjustment in interest rate swaps suggested “markets were finally taking our forward guidance seriously”. That is a reference to Mr Draghi’s near-constant refrain that the bank expects rates to “remain at their present levels for an extended period of time, and well past” the time when QE is finally brought to an end.
The ECB chief still faces significant communications challenges.
Bankers — particularly in Germany — are not happy about continued ultra-low interest rates. “The real economy is doing well, the market is expecting I think an increase in interest rates or a reduction in the negative nature of interest rates. Let’s start doing that,” said John Cryan, Deutsche Bank chief executive on Wednesday, referring to an issue that also concerns Mr Schäuble. “It can’t be forever that deposit taking is lossmaking . . . for banks.
The markets’ struggle to interpret Mr Draghi’s remarks over the summer has also fuelled sharp rises in government borrowing costs and contributed to the euro’s rise.
The currency’s ascendancy means in turn that a new round of economic forecasts by ECB staff on Thursday will almost certainly show inflation weakening in 2018 — complicating the bank’s task of explaining why now is the time to exit, even though next to no one expects inflation to hit its target during the next couple of years.
“If you look back at what he has accomplished in the past two or three years, Mr Draghi is probably the most successful central banker there is,” said Michael O’Sullivan, chief investment officer in the international wealth management division at Credit Suisse.
“But on the euro, he hasn’t been that forthright. There is a danger that if he doesn’t feel the need to say anything on Thursday, then the currency could draw investors and appreciate further.”
Ken Wattret, economist at TS Lombard, a research firm, said: “Inflation is still rather low, so the ECB needs to make clear that the hurdle to embark on interest rate rises is much higher than the hurdle to tapering.
“What Mr Draghi should do on Thursday is put some distance between adjusting QE and raising interest rates. He ought to emphasise that policy adjustment will be very gradual. Otherwise he risks undermining the progress which it has taken such a long time to achieve.
Additional reporting by Laura Noonan