Here’s the ECB’s `Strong Logic’ for Ending QE Before Rates Rise
The European Central Bank’s debate over the so-called sequencing of its exit from unconventional policy looks set to rumble gently on.
Executive Board member Peter Praet has led the defense of the plan to end quantitative easing first and only start raising interest rates later, saying the strategy is based on “strong logic.” As chief economist and the person responsible for presenting the board’s monetary-policy proposal to the Governing Council, his view carries enough weight to largely quash the idea that rates might rise before QE stops.
But the possibility hasn’t gone away, with at least two policy makers saying that there are situations which would justify raising the deposit rate, currently at minus 0.4 percent. So here’s a look at the arguments.
1. What is the current plan for exiting stimulus?
Beyond the ECB’s forward guidance, there isn’t one yet. The Governing Council intends to buy 60 billion euros ($66 billion) a month of debt until the end of 2017. What happens after that, such as whether and how asset purchases will be reduced, hasn’t been formally discussed. The ECB expects interest rates, which have been on a downward trajectory for more than nine years, to “remain at present or lower levels for an extended period of time, and well past” the end of QE.
2. How did the idea of a possible sequencing change come up?
The question of whether rates could rise before bond-buying comes to an end was raised briefly in the Governing Council’s March 9 meeting. That news, reported by Bloomberg the next day, pushed up the euro and bond yields. They were sent even higher a week later, when Austria’s Ewald Nowotny told a German newspaper that the ECB will need to discuss whether the Fed model “can be transferred to Europe one-to-one,” implying that rates could rise before the end of QE.
3. That market response can’t have gone down well?
It didn’t. Within hours of Nowotny’s remarks being published, Praet told Bloomberg that the ECB’s forward guidance on sequencing is “very clear” and that it has a “strong logical basis.” At a conference in early April, he reiterated that message and ECB President Mario Draghi tried to put a lid on the discussion by saying inflation is too subdued to start discussing any shift in the policy stance.
4. So what’s the ‘strong logic’ behind ending QE first?
Praet argues that the ECB should allow the yield curve to steepen by ending asset purchases before lifting it in its entirety via higher benchmark rates. He spelled that out in an interview with Trends magazine published on May 11:
“Look, there is a very strong chain of logic behind the decision to first scale back QE, raising the term premium included in long-term rates, and only then hiking short-term rates. We have to scale back our policy in an orderly fashion if we don’t want to undo the benefits of what we’ve been doing for the past few years.”
5. That seems, well, logical. Any other arguments?
Certainly. QE is an extraordinary measure introduced in 2015 as policy makers faced a critical threat of deflation, and after Draghi fought down numerous practical and political objections. German officials in particular have always said the program wasn’t necessary, and the ECB still attracts occasional accusations that it breached European Union rules prohibiting it from financing governments. Governing Council members critical of QE are likely to push a lot harder for it to end than for raising interest rates while bond-buying continues.
6. So what are the arguments for changing the sequencing?
Probably the strongest case would be if the negative deposit rate squeezes banks’ margins to the point of damaging monetary-policy transmission. Banks generally can’t pass the ECB’s charge for holding overnight funds onto customers, and while the central bank says it has no obligation to support lenders’ profit, it does care about the financial system’s ability to offer credit.
That scenario has been put forward by Executive Board member Benoit Coeure — who is about as influential as Praet — and acknowledged by Lithuanian Governor Vitas Vasiliauskas. Still, both men said they would need to see evidence of that risk manifesting, and so far they don’t.
Another argument is that changing the sequencing might give the ECB the flexibility to use all its policy tools for longer. For example, it could slowly tighten policy with a combination of small rate increase and a reduction in the monthly pace of bond purchases.
And there is an academic argument as well. Executive Board member Yves Mersch recently cited a Bank for International Settlements study that found nominal rates affect monetary-policy transmission independently of real rates. Keeping them persistently low might damp spending.
7. When will this be settled?
The Governing Council’s next policy meeting is on June 8 in Tallinn, where Praet is likely to urge his colleagues to fall in line or risk unsettling markets again. But unless the risk outlined by Coeure disappears, there’s no reason to drop that caveat. This isn’t the ECB’s biggest debate, so it doesn’t necessarily need to be resolved right away. But as the pressure for a full exit strategy mounts, investors may well be calling for more clarity.