The latest monetary decisions made by the U.S. Federal Reserve (Fed) and the European Central Bank (ECB) are keeping analysts very busy. The two key questions central bank watchers are grappling with are: Is the Fed going to tighten monetary policies earlier than expected and will the ECB be forced to enact a broad program of asset purchases, also known as quantitative easing (QE)? Finding the right answers matters as they will determine whether the monetary policies of the two central banks in Europe and America are set to diverge dramatically, with consequences both for interest rates and exchange rates.
Phasing Out Its Forward Guidance: The Fed
So far the prevailing view about the latest Federal Open Market Committee’s (FOMC) decision is that Fed Chair Janet Yellen is trying to have it both ways—in other words, signal to markets that the committee will not lift the foot off the gas pedal of ultra-loose monetary policies for a “considerable period of time,” while at the same time suggesting that the Fed could well revisit that decision if incoming data suggest that the economy is growing stronger sooner than expected. Investors, who still base their decisions on the Fed’s promise that it will continue to provide cheap and abundant liquidity, are starting to lose a clear time horizon, as the dollar continues to strengthen against its G10 peers and stock markets retreat from their recent highs.
Various top level Fed officials have since tried to qualify what “considerable period of time” means. Based on its current economic outlook the Fed expects that interest rates could rise sometime in 2015, but don’t bet on it if next year’s growth proves to be too modest. New York Fed President William Dudley, for example, suggests that excessive dollar strength could put downward pressure on inflation and growth and exchange rates need to be watched. So far—as Goldman Sachs points out in a note to clients—the dollar has primarily strengthened against a basket of advanced economies’ currencies, first and foremost the euro. Since officials in Washington are more worried about the negative impact of a weakening euro area economy on the United States than they are about a weakening of the euro itself, the recent dollar strength versus the euro is not yet a problem.
All Eyes On a Weakening Euro
As long as domestic demand remains weak in the euro area—and I don’t expect Germany to be willing or even able to stimulate the euro economy on its own—the monetary union needs to export more goods and import more inflation. That won’t happen unless the euro weakens against a wider basket of currencies, including some of the emerging economies. So far the common currency has mostly lost ground against the greenback and the British pound.
It was in the spring of this year that Mario Draghi, the President of the ECB, for the first time since the beginning of his tenure singled out the euro’s strength as one of the causes for the low inflation in the monetary union. This was a departure from previous statements in which Draghi stressed that the euro exchange rate moved well within its historical range. Ever since, it has become clear that one of the main objectives of the ECB is to weaken the euro, despite the fact that exchange rates are not an official target of the central bank’s monetary policy decisions. The sudden weakening of the German export-driven economy in the second quarter, due in part to geopolitical factors such as the crisis in Ukraine, made it somewhat easier to argue for a weaker currency. However, the big EU economies set to gain the most from the euro weakness are France and Italy.
The recent decisions made by the governing council, including lowering key interest rates, introducing negative deposit rates for banks that park liquidity with the ECB, launching a program of targeted liquidity injections (TLTRO) for banks willing to pass them on to the real economy, and last but not least, the plan to buy asset-backed securities and covered bonds will certainly contribute to a further weakening of the euro. However, whether those measures will sustain the current downward trend for a “considerable period of time” remains to be seen.
Weaker Euro Equals Bigger ECB Balance Sheet
In part, success depends on the ability of the central bank to get the ECB’s balance sheet back to where it was in 2012—in effect, on its ability to pump a trillion euros into the euro zone’s economy. This is where things get tricky, as many analysts doubt that Draghi can achieve this goal with the package of measures currently in place or about to be enacted. Draghi has never mentioned a deadline for achieving his goal of increasing the size of the ECB’s balance sheet. This gives him more time. But Francesco Papadia, a former top-level ECB official, thinks that Draghi’s goal of adding a trillion euros may perhaps be too ambitious: “Just to quote a figure, I would be very surprised if these purchases [of ABS] would reach 20 per cent of the foreseen increase; 10 per cent or somewhat more looks to me like a more reasonable figure. So, the heavy lifting would have to be done from the Targeted Longer Term Refinancing Operations (TLTRO). […] But a plan by the ECB to increase the size of its balance sheet by such a large amount largely by means of refinancing operations seems to be in contradiction with the fact that, since October 2008, […] it is commercial banks that determine the amount of central bank liquidity: how can the ECB plan a huge increase of its balance sheet when this is dominated by decisions of the aggregate banking system?”
In fact, the first allotment of TLTRO liquidity in September fell flat. While Papadia concedes that the offer is too generous to be ignored by banks—and the conditionality linked to the ECB’s TLTRO (i.e., increasing lending activity to the real economy) does not kick in immediately—banks are still in risk-off mode. They have dramatically reduced the size of their balance sheets in the past year and they may well have run out of eligible collateral needed to secure the loans that the central bank is offering. They could once again tap the sovereign bond markets and use government debt securities as collateral. But eventually they would have to use the extra liquidity for new lending to the real economy. All this makes the outcome of the December allotment a very important test. If it is not successful, markets will pressure Draghi to live up to his promises.
Euro Zone QE: Is It Coming?
Most investors expect that banks could remain reluctant to help Draghi achieve his goals. As a consequence, the ECB could be forced to unveil a program of broad-based asset purchases that include government bonds. In terms of timing, a propitious moment would roughly coincide with the Fed’s first rate hike sometime in 2015. Apart from cementing the narrative of the diverging paths of monetary policies in the U.S. and the euro zone, this would give euro area member countries enough time to demonstrate to the ECB (and Germany) that they are not only willing to speak about the need for structural reforms in their countries, but also capable of delivering them.
Some analysts expect the ECB to act earlier. Given the need for counterparties interested in a TLTRO to submit a reporting template four weeks before the next TLTRO is conducted, by November 20, 2014 the ECB will be able to make an early assessment on whether the December 11 allotment is going to be successful. This would be ahead of the December 4 meeting of the governing council.
Weathering Criticism and Managing Expectations in the Euro Zone
But regardless of whether QE will be launched, there is a new quality in Draghi’s public pronouncements. In the past he mainly criticized countries that are slow or unwilling to enact structural reforms, such as France and Italy. He has now expanded his range. Even the German government has been singled out by top ECB officials for its reluctance to do more to spur growth and domestic demand. This is a warning by Draghi to Berlin not to undermine recent monetary policy decisions. If current measures fail because of political headwinds, the ECB will be forced to launch QE. Low inflation both in core as well as peripheral countries gives Draghi plenty of political capital to shield himself against criticism from within the governing council as well as from outside.
Draghi’s recent words are an attempt to support current trends, especially with regards to the euro exchange rate, in the hope that the most recent decisions will be sufficient to support inflation and euro area growth. In the week from September 21-26, Draghi publicly reiterated four times that the governing council is determined in its fight against excessively low inflation. It would be a grave mistake if he backpedalled and sounded too hawkish in his public remarks following the next governing council meeting on October 2. I doubt that he will.
In 2012, the president of the ECB provided the euro area with a parachute called Outright Monetary Transactions (OMT). The next months will prove whether he can also contribute more decisively to lift the economy out its current misery. QE is the ECB’s true weapon of last resort. It can act both as a parachute and as a stimulator. It is also a highly political tool that Draghi can use against the reluctance of governments to act. I still believe that he will only launch QE it if it becomes absolutely necessary.