The European Central Bank is in a near-insoluble dilemma over quantitative easing as it prepares to adjust monthly bond-buying on 8 December, just after Italy’s 4 December constitutional reform referendum that will decide Prime Minister Matteo Renzi’s political future.
Similar soul-searching – reinforced by Donald Trump’s US election win and expectations of higher US interest rates – is taking place at the Bank of Japan, the other big central bank engaged in a massive QE programme. Already there are preliminary signs that the bank is acquiescing in higher interest rates on Japanese bonds and may rein back the ¥80tn a year purchase programme that Haruhiko Kuroda, the BoJ governor, has hitherto termed sacrosanct.
The BoJ may also bow to market pressure for higher yields by raising from zero to 0.1% or 0.2% its cap on 10-year interest rates under a yield curve-targeting policy announced with great fanfare in September.
Depending on the outcome, the Italian poll – determining a new Chamber of Deputies-Senate power split and, indirectly, the fate of Italy’s problem banks – could have a similar impact on Europe to France’s April 1969 referendum on President Charles de Gaulle’s proposed constitutional changes.
De Gaulle’s resignation after the 1969 No vote helped spark a chain of events that led to a devaluation of the French franc against the D-mark, the entry of the UK into the European Economic Community and the breakdown of the Bretton Woods system of fixed exchange rates.
The ECB’s decision on whether and how to continue its €80bn a month bond purchase programme beyond the present cut-off date in March 2017 will be overshadowed by the meeting of the Federal Reserve’s rate-setting committee on 13-14 December. This is widely expected to decide only the second increase in 10 years in US interest rates. Expectations of higher inflation and bond market rates have been driven by the probable reflationary consequences of Trump’s promised tax cuts and infrastructure spending.
The shorter-term drama will be focused not on America but on Europe. If Italians vote to reject Renzi’s proposals, political uncertainty could widen spreads between Italian and German government bonds – already the highest since 2014. This could significantly worsen the outlook for several Italian banks hard-hit by non-performing loans, confronting some of them with the spectre of collapse.
In such fraught circumstances, the ECB might have little choice but to maintain the €80bn a month programme beyond March, in spite of heated opposition from the Bundesbank and other ‘hard money’ ECB constituent central banks.
Such a measure, in spite of both a stronger dollar and higher anticipated euro area inflation, would almost certainly meet considerable criticism in Germany and elsewhere. It would indicate that the ECB was guided in its QE programme less by monetary policy considerations and a desire to increase inflation towards the 2% level, and more by the need to shore up Italy’s economy and banks.
If Italy votes Yes on 4 December, the ECB will have a greater incentive to start ‘tapering’ its asset purchases, either by running down the monthly purchases to zero over a set period or by buying a smaller monthly volume over a longer time, with a possible option for reductions to zero depending on international bond yields. Tapering would be a gamble that could reignite a widening of yield spreads, but would meet widespread objections that the ECB’s excessive easy policies since 2012 are creating counterproductive distortions.
As Jens Weidmann, the Bundesbank president, has put it, intended ECB monetary policy effects are diminishing over time but unwanted side effects are increasing. He has opposed the ECB’s QE continuously but fruitlessly since it started in Match 2015.
The Bundesbank argues that a further reason to lower the asset purchase programme is to prevent a further fall in the euro. This would not only damage the single currency’s credibility in northern Europe but also increase the already very large German and Dutch current account surpluses and provoke more criticism – not least from Washington – on Germany’s role in international economic imbalances.
Another reason for tapering would be because higher bank equity prices since Trump’s election have outweighed higher bond market interest rates as an indication of more accommodative overall financial conditions.
On the other hand, QE defenders, at present in a strong majority on the ECB’s 26-person governing council, say that expectations of higher inflation are not yet deeply enough entrenched to allow the central bank to slacken substantially its bond purchase efforts. Additionally, they say, the latest rise in intra-euro area spreads needs to be countermanded by fresh QE to prevent dangerous credit tightening. One possibility under consideration is that the ECB could on 8 December signal an eventual turnaround in interest rates by withdrawing its habitual statement that rates are expected ‘to remain at present or lower levels for an extended period of time, and well past the horizon of our net asset purchases’.
Modification of ‘forward guidance’ would be a signal that, after continuous easier credit policies since Mario Draghi took the ECB reins five years ago, the bank is slowly moving towards ending stimulus. One of Draghi’s principal worries, however, is that his manoeuvering room will be powerfully affected by a member state widely regarded as the euro bloc’s weakest link, his native country Italy.
David Marsh is Managing Director of OMFIF.