Has the ECB started to tighten the screws?

Christian Odendahl
08 December 2016

Given the continued weakness of inflation, the ECB was always going to extend its bond purchasing programme (‘quantitative easing’ or QE) beyond its previously scheduled end in March 2017. The question was how, exactly, the ECB would extend it. The ‘doves’ in favour of continued expansionary monetary policy hoped for a clear signal that the ECB was not going to rein in the programme until inflation was safely back at the target level of 2 per cent. The ‘hawks’ critical of the ECB’s expansionary stance hoped that it would make clear that the end of QE was nigh. Today the ECB decided to give a mixed signal.

Bond purchases will be reduced to €60 billion a month (from €80 billion) by April 2017, but run until December 2017, longer than planned. The cut in monthly bond purchases is the signal that the hawks had hoped for, even though the extension until December 2017 is longer than they would like.

But Mario Draghi also gave three dovish signals. First, the ECB decided to include bonds whose yields are below the ECB deposit rate; that is, the rate the central bank pays on banks’ excess reserves at the ECB. So far, the ECB had excluded buying such bonds for fear of being attacked for making ‘losses’ on its purchases. (That criticism was always economically questionable, but the ECB in the past decided it was not worth the hassle.) With this restriction gone, the ECB can extend QE, as it was running out of German bonds to buy (many short-term bonds of ‘safe’ countries have a negative yield, some below the deposit rate). As a result of that announcement, yields on short-term bonds fell, taking the euro down with them.

Second, the ECB published its revised economic forecasts. While there was no real change to its projections for 2017 and 2018, its first forecast for 2019 showed that the ECB is still predicting its own failure: inflation is expected to be just 1.7 per cent in 2019, which is — in Draghi’s own words — out of line with the ECB’s target of ‘just below 2 per cent’. Such a forecast for 2019 is dovish because it signals that the ECB expects monetary policy to be accommodative for a long time.

Third, Draghi made clear that rates will stay low even after the asset purchases have stopped. This statement was meant to reassure markets that the exit from QE would not be followed by a quick rise in interest rates.

Today’s ECB decision was a compromise between hawks and doves, but overall the doves narrowly won. But the ECB has set itself up for criticism if and when a recovering oil price drives inflation above the ECB’s current projections. Will it start tightening monetary policy in that case? That would risk snuffing out the eurozone’s fragile recovery.

Christian Odendahl is chief economist at the Centre for European Reform.