Copyright BieResearch.com 2018 1

Euro area

Time to say goodbye (to QE)

7 February, 2018

Ulrik Harald Bie, Independent Economist, ulrik@bieresearch.com

www.bieresearch.com

• ECB has lost grip of the monetary-policy narrative

• The economy is doing too well for extraordinary measures …

… but ECB is unwilling to signal a change out of fear of euro appreciation

• Current forward guidance is set to be revised during the year

• Interest rates to remain low for long as inflation remains elusive – but will not stay negative

Draghi on the defensive

The latest market turbulence is closely linked to the

decade-long unlimited supply of central bank liquid-

ity at zero cost. Federal Reserve timidly embarked on

normalization in 2013 and is likely to proceed at the

gradual pace of four rate hikes this year – unless fi-

nancial markets tank completely. For the new Chair-

man Powell, this is a defining moment: Support the

stock market and investors know there is no down-

side risk. Ignore the correction and risk large wealth

destruction.

For the ECB the situation is even trickier as the Euro-

pean economy has gained momentum. Federal Re-

serve’s challenge is whether to stay on the set course.

ECB’s challenge is to chart a course in a post “what-

ever it takes”-world. ECB President Draghi has tried

to kick the monetary-policy can far into 2018 by ce-

menting the open-ended commitment to quantitative

easing (QE) and negative interest rates, but financial

markets have called his bluff. German 10Y yields has

more than doubled since Christmas (even including

latest safe-haven flows), and the euro is up 5% against

the dollar since mid-December and 13% on the year.

It is time for ECB to recalibrate the monetary-policy

narrative.

“Whatever it takes” has been a success

ECB previously had to deal with an aggressive central

bank in Washington. The extraordinary measures un-

dertaking by the Federal Reserve during the financial

crisis forced the dollar down in 2009, 2010 and 2012.

It was not until ECB undertook its own “whatever it

takes” in 2014 that the euro finally responded by de-

preciating 32% against the dollar over ten months. It

Copyright BieResearch.com 2018 2

is fair to assume that without the currency effect, euro

area inflation – already dragged down by oil prices –

would have been pushed further into deflationary ter-

ritory, although in the euro area the correlation be-

tween inflation and oil prices is much stronger than

between inflation and the exchange rate.

ECB’s extraordinary measures in 2014 and 2015 were

aimed at defusing the risk of deflation with an im-

provement in the credit channel as the most im-

portant stated goal, but also to reduce the fiscal pres-

sure on governments undertaking structural reforms.

However, the untold subgoal was also to instigate a

weakening of the euro to generate inflation, and to

spur exports at a time when the domestic economy

was still suffering from the euro crisis.

Measured against almost all parameters, ECB’s strat-

egy has been a success. The improvement in the

credit channel has eased credit conditions and

brought down private-sector financing costs. Lending

has picked up and financial-sector challenges in the

periphery countries are being dealt with. Low financ-

ing cost and a better growth outlook has prompted a

reversal in the sovereign credit ratings, now improv-

ing across the euro area.

The increase in German yields since Christmas has

been met by a corresponding decline in spreads to

Southern Europe; even Italy has been able to steady

yield levels despite heightened political risk. The lat-

est market turbulence has not led to a flight out of pe-

riphery bonds. These are very important achieve-

ments. Further spread tightening should mitigate the

upward pressure from rising German yields – and the

levels are still close to historic lows.

GDP-growth in the euro area reached 2.7% in 2017

and confidence indicators are at record highs. Unem-

ployment has dropped and is heading towards the all-

time low of 7.3% reached in early 2008. Pension and

labor-market reforms mean that unemployment can

go even lower without triggering excessive wage in-

creases. In June 2017, ECB upgraded the risk to the

growth outlook to broadly balanced; the economy has

surprised massively on the upside since then. When

ECB moved to a balanced risk outlook, GDP-growth

was forecasted to reach 1.8% in 2018; now that fore-

cast is 2.3%. I expect further upward adjustment to

the growth outlook at the upcoming ECB-meeting.

Inflation gone missing

The achievements on growth and unemployment (as

well as the weaker euro) allowed ECB to tone down

the risk of deflation during 2017. However, while the

extraordinary measures have long achieved their

Copyright BieResearch.com 2018 3

goal, the measures continue to apply; bond purchases

will remain in place at least until September, and

Draghi also stated at the January meeting that “I see

very few chances at all that interest rates could be

raised this year.”

Moreover, ECB maintains an asymmetrical bias to-

wards further easing, even while recognizing the im-

proved growth outlook. The simultaneously un-

changed forward guidance and strengthening busi-

ness cycle means that the divergence between the real

economy and the monetary-policy narrative has

grown too large; ECB has lost credibility by not mov-

ing and markets have responded by repricing the

euro and yields.

It all comes down to inflation. In the past years, ECB

has severely underestimated the decline in unem-

ployment – and overestimated the pick-up in infla-

tion. That is a clear indication of a breakdown in the

previous model-based relationship between eco-

nomic growth and inflation. When the unemploy-

ment rate was last at the current 8.7%, core inflation

was 1.9% and the monetary policy rate at 3%. Now

core inflation is 1.0% and the deposit rate is negative.

There are some indications of increasing inflationary

pressures. In Germany, the recent agreement be-

tween IG Metall and employers include wage increase

of just below 4% in 2018 and 2019 with improved

flexibility on working hours. Although wage increases

in the service sector are likely to be lower, compensa-

tion in Germany is finally responding to the tight la-

bor market – and the changed political dynamics.

ECB cannot ignore this piece of the puzzle, although

it remains to be seen whether higher wage costs will

impact inflation or just lead to higher investments in

machinery and technology.

Regaining control

While I firmly believe that labor and product market

reforms, free movement of labor and capital as well

as a technological revolution has lowered the natural

rate of inflation towards zero, central banks’ ability to

generate higher real-economy inflation (rather than

just financial inflation) has not gone away. However,

the needed monetary stimulus to push inflation up to

2% is much greater than before, thus increasing the

risk of generating bubbles in asset prices and exces-

sive debt accumulation.

The question for ECB is whether maintaining the cur-

rent monetary policy is worth the risk; the longer ECB

waits to take the next steps towards normalization,

the less credible its message becomes. The process is

also muddled by the departure in 2019 of the two

Copyright BieResearch.com 2018 4

chief advocates for a slow approach: President Draghi

and Chief Economist Praet. It would be useful if nor-

malization is well under way before the baton is

passed on – as Yellen did at the Federal Reserve.

The monetary-policy hawks are already asserting

themselves led by Knot (Netherlands) and Hansson

(Estonia). Jens Weidmann (Germany) has so far sent

more centrist signals, but likely remains on the hawk-

ish side; as does Lautenschläger (ECB Board). Draghi

will have to decide what level of public disagreement

ECB can accept and probably for the first time in his

tenure make significant concessions. In the coming

months, I expect ECB to give up some elements of the

current monetary-policy strategy; to decouple the ex-

traordinary measures (and deflation risk) from “nor-

mal” normalization that is going to be prolonged be-

cause of the low structural inflation.

These are the main milestones:

• Reconciling forecasts

ECB has increased the GDP-forecast during 2017 but

has left the inflation forecast virtually unchanged.

However, survey-based inflation expectations have

moved up over the last months, particularly in house-

hold surveys. Global inflation expectations have also

firmed, partly reflecting higher oil prices. The ECB

staff projection in March is likely to upgrade the in-

flation outlook.

• Terminate QE

ECB needs to change the monetary-policy statement

to reflect an end to QE in September. This is likely to

happen in June. The asymmetrical bias towards more

easing should also be eliminated here. Using Federal

Reserve’s playbook, ECB could add a phrase reflect-

ing data-dependence in making the final call on QE at

the September meeting.

• Terminate negative interest rates

After QE ends in September, ECB has to find a way to

signal that the first round of rate hikes (away from

negative rates) is forthcoming. The challenge is to

separate this phase from the ensuing “normal” inter-

est rate normalization. Federal Reserve stated that

interest rates were to remain unchanged for a “con-

siderable time” after the end of QE in October 2014.

That changed to “patient” in January 2015 and mor-

phed into a discussion about when a rate hike was

“appropriate”. The first rate hike came in December

2015. ECB is likely to remove “extended period” and

“well past” from the policy statement already in Oc-

tober and take the deposit rate back to zero in

1Q/2019. I expect a pause in Q2 and a glacial pace af-

terwards with no more than four hikes per year.