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When the Governing Council of the European Central Bank meets later today all eyes and ears will be on any hints from the ECB on when it will start its policy normalization process. However, the central bank in unlikely to be straightforward and this may leave markets wanting.
Given the current economic assessment there is a broad consensus that the ECB will be reducing the pace of monthly asset purchases from January 2018. This will be the next phase in a monetary process that may take years to conclude. The ECB will likely start by gradually reducing the volume of asset purchases, often referred to as ‘tapering’.
Tapering will be accompanied by interest rate adjustments and eventually contraction of the balance sheet.
Currently the ECB, apart from holding its main refinancing rate at 0%, also regularly buys government bonds from the market. The basic effect is an increase in money supply which translates into what any economics student read in chapter one of any textbook. Thus, the result is lower market interest rates, economic growth, lower savings, more consumption and inflation; not necessarily in that order.
The scaling down of the asset purchases will mainly impact the magnitude but not the direction of the variables. Still, if the ECB were to clearly announce its intention to start the tapering process today, the immediate impact on equity markets may be substantial.
However, this may be unlikely given the complex series of factors that characterize the present environment. The Eurozone economy has improved substantially and forward-looking indicators appear generally encouraging. The Euro, riding on this economic recovery and weakness in rival currencies is starting to act as a headwind, threatening competitiveness and consequently inflation. Any clear hints of monetary tightening will only serve to strengthen the Euro further risking gains made on the inflation front.
Since the start of the year the Euro has gained 13.7% against the US dollar and 6.8% against the UK pound. Normally this would act as an automatic economic stabilizer over time, however, given the fragile state of the current economic recovery, it is more likely to serve as a direct headwind to growth by making exports less competitive and imports cheaper.
The other side of the coin sees concerns that a loose monetary policy encourages excessive risk-taking. Asset prices currently do not necessarily price in risk correctly. It is exhibited in higher PE ratios in the equity market and ultra-low yields in the bond market. The risk of financial bubbles getting out of hand increases the longer monetary policy remains loose.
The ECB will probably continue to prepare markets for the start of the long process of normalizing its aggressive monetary policy. However, the strong Euro limits the ECB’s margin of error, and thus the Council may opt to postpone the announcement to October.
Still, tapering is eventually unavoidable. Thus the balance is between clarity today, a stronger Euro and its effects, or postponing the decision and leaving inventors guessing. I do not see any immediate positive either way.
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