(Bloomberg) — The European Central Bank’s new message on how long it’ll keep interest rates low is supportive for the economy and risky for markets.
President Mario Draghi raised the bar for any future policy tightening with a pledge that a new round of quantitative easing will end only “shortly before” key interest rates rise. That commitment was meant to reassure investors that the stimulus will continue until inflation is solidly back in line with the goal of just under 2%.
Yet the flip side is that when price growth is looking robust, markets face the prospect of an end to bond-buying and a rate increase coming almost instantly. While such a scenario might be years away from happening, the ECB’s current guidance could mean the tightening happens too quickly.
“Is this something that’s going to come back to bite them further down the line? Potentially,” said Jefferies International economist Marchel Alexandrovich. “They’re trying to deal with the problem that’s immediate.”
In a contentious decision at Draghi’s penultimate policy meeting, the ECB decided to restart asset purchases, cut interest rates to minus 0.5% and ease the terms of its program of long-term loans. The Governing Council also dropped its previous guidance that rates will stay unchanged or lower at least until mid-2020. Instead it said both rates and QE will be tied exclusively to the progress of inflation.
The ECB has been undershooting its goal for price growth for most of the last decade and its recent forecasts don’t see it returning to the objective until at at least 2021. The promise of almost unlimited stimulus makes sense until you have to remove it.
In 2013, the U.S. Federal Reserve’s signal that it was ready to reduce the pace of its purchases caused the so-called taper tantrum, battering markets across the globe as investors panicked over the impending squeeze on liquidity.
As the euro zone eventually moves closer toward its own inflation target, the ECB will also face the dilemma that the very fact that it’s reaching the goal could trigger a negative reaction from the markets.
“The risk of a QE taper tantrum has gone up due to the link to the onset of the rate hiking cycle,” said Martin van Vliet, a rates strategist at Robeco. “Nothing has been set in stone. The ECB has said they expected to continue net QE until shortly before they start raising rates. Expectations can change.”
The central bank’s own inflation projections currently see prices rising at an average pace of 1.5% in 2021, still clearly below the target. Chief Economist Philip Lane has said he is “not going to disagree” with the estimate that the latest stimulus package should push up inflation by 20 or 30 basis points.
“This was meant as a dovish reassurance: they won’t stop asset purchases until they are so sure about inflation being back at target that they could hike,” said Antoine Bouvet, a senior rates strategist at ING Groep (AS:) NV. “In reality, it is questionable they will manage to do both in short order because of the potential for an adverse market reaction.”
For Gilles Moec, chief economist at Axa SA in London, it would be better for the ECB to have the freedom to use both instruments — rates and quantitative easing — separately. It’s possible, for example, that policy makers may want to stop buying bonds because of the improvements in the economy but still keep rates low to prevent the currency strengthening.
“The market isn’t fixated on this right now, but it will end up being a problem so my guess is they will have to change their forward guidance at one point,” Moec said. “I don’t think it’s their last word.”
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