Towards Draghi’s first monetary tightening

ECB forward guidance gradualism: ‘Make haste slowly’

The European Central Bank appears to be preparing to jettison the idea of further cuts in negative interest rates, signalling a possible rise ahead of a gradual decline in its monthly quantitative easing asset purchases over the next year.

The change in the ECB’s ‘forward guidance’ on interest rates could come as early as the next meeting of the governing council on Thursday. This would be a compromise between the more hawkish views of a minority on the 25-person council, led by Germany’s Bundesbank, and the majority faction under Mario Draghi, the ECB president. The latter is arguing for continued easy money to withstand European and worldwide uncertainties.

Such a move would be the first monetary tightening since Draghi took over at the ECB in November 2011. This would be an important landmark that could win him some favour among orthodox German monetary economists who have long criticised his dovish tendencies.

Since October the council has repeated at every meeting that it expects key ECB interest rates to remain ‘at present or lower levels for an extended period, and well past the horizon of the net asset purchases.’

However, expectations of accelerating US interest rate rises following Donald Trump’s election, as well as a February increase in euro area inflation to the targeted 2%, has made the ECB’s cautious wording seem increasingly anachronistic.

Signalling a small rise in the ECB’s deposit rate of minus 0.4% – in force since March 2016 – while confirming monthly asset purchases of €60bn (prevailing from next month, down from the previous €80bn) would recognise that the ECB antideflation policy of QE plus ultra-low interest rates is starting to work.

This step would appease German economists irked by a faster rise in German inflation – even though it has long been evident that higher-than-average German inflation is a precondition for restoring economic and monetary union to better health. More widely, a return to higher but still negative interest rates, blamed for weakening banking profits around the euro area, would be welcomed in most EU financial capitals.

Such a change would match the thinking of Yves Mersch, the Luxembourg-born member of the six-strong ECB executive board, who often occupies the middle ground between the Bank’s softer and harder monetary factions. He asked in a speech in Germany on 10 February, ‘How much longer can we continue to talk about “even lower rates” as being a monetary policy option?’ To protect the ECB’s ‘credibility’, he said, ‘there should be no delay in making the necessary gradual adjustments to our communication’.

The ECB council appears united in not wishing any precipitous reversal of highly accommodative monetary policy. The watchword is: ‘Make haste slowly.’

Memories remain vivid of misguided ECB tightening in 2008 and 2011 under Jean-Claude Trichet – Draghi’s predecessor – which undoubtedly worsened the economic consequences of Europe’s sovereign debt crisis.

Persistence of QE, as well as negative interest rates, conflicts with mainstream Bundesbank thinking. The German central bank held out for a long period against QE. It reluctantly agreed to negative rates in 2014 as a means of staving off QE, until it was forced to go along with majority opinion in favour of QE starting in March 2015.

The Bundesbank line appears to have softened, however, over the intervening two years. This corresponds to a general German requirement to maintain calm in money markets during this year’s sensitive round of European elections. The ascent of the strongly pro-European Martin Schulz, of Germany’s Social Democratic party, as a challenger to Chancellor Angela Merkel in September’s German elections is prompting Merkel into a more positive line on European integration. Worries about the French election and the rise of the anti-euro National Front are having a similar effect.

Views appear to be hardening that Jens Weidmann, the Bundesbank president, may become Draghi’s successor in 2019. This necessitates softer German euro policy in the next two years, including acquiescence in the rise of the Bundesbank’s Target-2 claims on the ECB under EMU’s payments settlement system.

Draghi can be pleased that a combination of QE and negative interest rates, as well as spurring credit growth, has helped promote a euro area recovery by weakening the exchange rate. Since making an unusual intervention in August 2014 by saying, ‘The fundamentals for a weaker exchange rate are today much better than they were two or three months ago’ and ‘other central banks have been reducing their exposure to the euro’, the euro has weakened by 24% against the dollar – an important reason for the brighter European economic picture.

David Marsh is Managing Director of OMFIF.

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