European Central Bank’s decision to reduce asset purchases not a true indicator of bloc’s economic health

Slowed pace of purchases is likely to be accompanied by commitment to keep benchmark rates lower for longer

PUBLISHED : Tuesday, 24 October, 2017, 12:07pm
UPDATED : Tuesday, 24 October, 2017, 10:42pm

The European Central Bank (ECB) is set to announce on Thursday a timetable for reducing the size of its monthly asset purchases amid signs the euro zone economy could expand in 2017 at its fastest pace for a decade. But investors should be wary. Economic, political and social fault lines remain beneath the surface of the economic bloc.

Economists polled by Reuters expect that, from January, the ECB will announce it is to trim its monthly asset purchases to 40 billion from the current 60 billion, with the programme to continue for another six to nine months. However, that does not mean an early end to very low or negative benchmark rates in the euro zone.

Reining in the pace of asset purchases is likely to be accompanied by a commitment to keep euro zone benchmark interest rates lower for longer. The ECB will be mindful that euro zone inflation, presently at 1.5 per cent, remains substantially beneath its target of close to but below 2 per cent.

It may be that the ECB asset purchase taper is a case of making a virtue out of a necessity.

Having acquired more than 2 trillion of paper already, mainly in the form of euro zone government bonds, as part of its asset purchase programme, the ECB, which is operating within self-imposed accumulation limits, might anyway soon find that its ability to add further purchases of some nations’ debt is constrained.

As for the time frame, there is an argument that “the longer the ECB takes to pare back its net asset purchases to zero, the further into the distance the subsequent steps in the normalisation process become”, as Ken Wattret, the managing director of global macro at investment research company TS Lombard, wrote this month.

The longer euro zone benchmark interest rates remain lower – and with the ECB’s current deposit rate still at minus 0.4 per cent – arguably the more potential there is for anomalous situations to build up as investors pursue yield in euro-denominated bonds.

For example, based on data from the economic research website of the St Louis Federal Reserve, the yield on Bank of America Merrill Lynch’s Euro High Yield Index, where the corporate debt components are all below investment grade, was 2.17 per cent last week. Yet on Friday, the yield on the benchmark 10-year US treasury hit 2.39 per cent.

Junk was paying less for money than Uncle Sam.

It is a topsy-turvy world but investors might wonder how long such anomalies can continue as asset purchases are pared back, even if the ECB still remains a long way off from raising its own benchmark interest rates.

Setting aside the still subdued level of euro zone inflation, the ECB may also be making the calculation that lower for longer interest rates will temper any further rise in the value of the euro on foreign exchanges, a rise which would undesirably bear down on imported inflation but also negatively affect the competitive position of euro zone exporters in global markets.

If such a calculation betrays an underlying but unvoiced concern that the euro zone economy is essentially still too frail to afford a materially stronger currency, it might nevertheless still be a stance that is well-grounded.

The data might show an improvement in the euro zone economy but the rising tide is not raising all boats equally. Intra-bloc economic and social divergences remain.

As Pierre Moscovici, the European Commissioner for Economic and Financial Affairs, said last week, those divergences “undermine the promise of shared prosperity, which was central to the creation of the euro in the first place. And they fuel populism in regions where inequalities have been felt more strongly”.

Given that elimination of such divergences would have to involve fiscal transfers from richer to poorer countries within the euro zone, it is highly questionable if the political will exists in wealthier countries, such as Germany, for such redistribution.

It is hard to see how the next German government, which will almost certainly include the Free Democratic Party (FDP), could back such moves. FDP leader Christian Lindner has already dismissed France’s President Emmanuel Macron’s idea for a European Monetary Fund as “a pumping station for financial transfers”.

Meanwhile in Spain, the pressure for independence in Catalonia is at least partly driven by a belief that Catalans pay more into the coffers of the Spanish state than the region gets back.

All in all, the ECB’s incremental withdrawal of monetary accommodation makes perfect sense but the central bank’s approach reflects the euro zone’s continuing economic frailty. The fault lines in the currency bloc remain.