Banking dilemmas Robust euro to keep ECB policy stuck on hold

The ECB is under pressure to drop its "easing bias" at Thursday’s council meeting. But the euro's strength and political gridlock in Italy speak for a no-change message.
Loud, perhaps, but not always clear.

When the European Central Bank’s governing council meets on Thursday, its members will face growing pressure to tweak their message to financial markets and signal a monetary tightening is on the horizon.

The bank has drawn flak for sticking to its pledge to increase its bond-buying program, either in size or duration, if the euro-zone's economy deteriorates. As it happens, the region's economy grew 2.5 percent last year, its fastest rate in a decade. Dropping that promise – the so-called "easing bias" that flags the ECB's accommodative policy – would suggest the bank believes euro-zone prices are increasingly aligned with its inflation target of just under 2 percent. But that goal may be some ways off: Consumer prices rose just 1.2 percent in February, a slowdown from 1.3 percent a month earlier.

Members of the ECB Shadow Council, an independent advisory group of 15 leading European economists set up in 2002 by Handelsblatt, said it’s time for the central bank to revoke the pledge. “It no longer fits in with the economic situation,” José Alzola, an economist of the Observatory Group, an advisory firm, told Handelsblatt. “The ECB can be confident that price stability is secured,” said Elga Bartsch, chief European economist for Morgan Stanley.

The easing bias no longer fits in with the economic situation. José Alzola, economist at Observatory Group

The ECB has pledged to buy €30 billion ($37 billion) of euro-zone bonds every month through at least September. That promise is a pillar of its €2.5 trillion quantitative easing program, launched in 2015 as inflation was falling and the euro zone was in danger of slipping back into recession.

ECB President Mario Draghi has indicated that the program won’t end abruptly. Ms. Bartsch agreed that it would be unwise for the ECB to set a date for an end to quantitative easing, because that could trigger a euro rally and hurt euro-zone growth. But if the bank gradually scales back its bond-buying starting in September, expectations of an interest-rate hike would be postponed, lessening the upward pressure on the currency. The euro already rose 14 percent against the US dollar in 2017.

So far, however, the ECB has refrained from sending a clear message to that effect. Mr. Draghi and his colleagues obviously fear that a change to this stance could cause turbulence in financial markets. It’s a classic central banking dilemma: The more clearly a bank defines its future policy, the stronger the pre-emptive reaction in the markets will be, and that’s precisely what the bankers don’t want. They want their policies to have a gradual impact on markets so that businesses and investors have time to adapt.

But critics warn that the lack of clarity means that markets react very strongly to any information they get. That situation was highlighted in January, following the publication of the minutes of the ECB’s December council meeting that suggested policymakers could soon start preparing markets for the end of the bank’s stimulus scheme. The euro soared as a result.

If the ECB drops its accommodative stance, one thing is certain: The euro will strengthen and bond yields will rise.

Will the bank change its tune on Thursday? Probably not. Policymakers are expected to discuss dropping the easing bias, but will probably wait until the summer before actually doing so, economists said. If it unexpectedly drops the bias, one thing is certain: The euro will strengthen and bond yields will rise.

The ECB may decide that Thursday is too soon to announce changes because of the recent market volatility, the strength of the euro and political gridlock in Italy after Sunday’s general election. The euro-zone’s third-biggest economy faces prolonged instability after voters delivered a hung parliament, making Chancellor Angela Merkel’s six-month struggle to form a German government look like a piece of cake.

But investors still anticipate an ECB interest rate rise in early 2019. Andrew Bosomworth, head of portfolio management in Germany at PIMCO, said the ECB could help markets by following the example of the Federal Reserve, which publishes forecasts of its council members for leading interest rates in the coming years.

Another member of the ECB Shadow Council, Sylvain Broyer of French investment bank Natixis, called on the ECB to start “talking down the euro,” for example by saying it’s currently overvalued. Officially, the ECB has no foreign exchange target and the world’s leading central banks have agreed not to try to seek one-sided advantages by steering their currencies’ exchange rates.

But Mr. Broyer said that in effect, central banks are locked in a “currency war.” At his previous news conference, Mr. Draghi expressed veiled criticism of US Treasury Secretary Steven Mnuchin for influencing the euro’s exchange rate with his remarks.

Since then, trans-Atlantic relations have deteriorated with President Donald Trump announcing duties of 25 percent on imported steel and 10 percent on aluminum to protect US producers. The European Commission has threatened countermeasures. If a trade war erupts, conflict over the exchange rate will likely intensify, opening a new and highly unwelcome battlefront for Mr. Draghi.

Jan Mallien and Frank Wiebe cover monetary policy for Handelsblatt from Frankfurt. David Crossland and Jeremy Gray adapted this story into English for Handelsblatt Global. To contact the authors: [email protected] and [email protected]