Few interventions in history of central banking have been as dramatic as the European Central Bank’s expansion of its balance sheet to over €4tn to support the eurozone. The strengthening economic recovery in the eurozone and pick up in inflation mean the debate on how to make an elegant exit from its emergency measures is becoming critical.
The ECB’s success in staving off deflation and preventing a break-up of the euro, often single-handedly, has been Herculean, but it has led to many distortions. The turnround, the point of inflection between deflation and inflation, could come rather faster than might be comfortable for the ECB, and requires a rethink of its exit strategy from unconventional and expansionary monetary policies.
The market’s working assumption has been that the ECB would follow the lead of the Federal Reserve. First reduce the scale of asset purchases, then raise rates and then, very slowly, address the €4tn balance sheet. This may prove to be too slow and gradual should economic recovery, and inflationary pressure, really start to take hold. What’s more, the US never undertook the dangerous experiment of negative rates, probably the biggest policy mistake in central banking since the financial crisis.
It would not only be feasible but actually beneficial to start raising eurozone interest rates from their present negative level, before ceasing to buy further amounts of government debt.
Negative rates have been highly corrosive to banks’ earnings and broader confidence in the banking system, as I have argued before. Given some 80 per cent of business lending in Europe comes via banks, in stark contrast to the US, one cannot ignore the damage being done. Last year eurozone banks made returns of just 5 per cent, no better than 2015, as negative rates dragged down the top line for banks. An unprofitable banking system risks financial stability and is unable to support economic growth. Little wonder the eurozone’s chief banking supervisor, Danièle Nouy, highlighted bank profitability worries a dozen times at the ECB’s annual bank supervision press conference.
Second, the policy mix risks becoming unbalanced. Last month the ECB’s Targeted Longer-Term Refinancing Operations, an Alice Through the Looking Glass scheme that paid banks to lend, came to an end. This policy was designed to ameliorate the harm negative rates would have on eurozone banks. It was meant to nudge banks to lend to companies. While there is little evidence that bank lending is higher as a result of this scheme, it came as a helpful offset. Anyone who doubts this should look at the size of the final round. Banks took €233bn in one day, in effect offsetting 11 months of the ECB’s announced tapering at €20bn per month. As the TLTRO2 scheme is being wound up, we will have an unbalanced negative rate policy.
Third, the Fed now looks likely to raise the official rate three times through 2017. Unless the ECB starts to raise interest rates in line, the margin between short-term rates in the eurozone and in the US will grow quite significantly. It could well put downward pressure on the euro against the dollar, creating inflationary pressure in the eurozone.
Finally, the other benefit of addressing negative rates first is to maintain indirect support for peripheral sovereigns by keeping government borrowing costs in check. Given the political uncertainties in Europe, it could seem foolhardy to withdraw an instrument that helps in this respect.
The biggest challenge to reversing negative rates first is whether it may challenge the credibility of central bank forward guidance today, or in a future crisis. However, the precedent for adjusting rates without undermining forward guidance is strong. The ECB itself has cut rates twice since quantitative easing began, as it became more concerned about deflation. So it could increase rates twice if it was clearly communicated that the central case for inflation and the economy were improving, and tail risks falling. In effect, the ECB would be exiting via the door they came in by.
To make an elegant exit, a gradual policy adjustment should dovetail with a more expansive fiscal policy where possible, greater investment in infrastructure and progress on diversifying the sources of capital for Europe’s companies and infrastructure projects.
Getting the policy mix, sequencing and communication right will be crucial to avoid an inadvertent harsher tightening of financial conditions. Investors will need to be alert to a shifting policy mix.
Huw van Steenis is global head of strategy at Schroders
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