ECB faces a daunting uphill battle to raise interest rates
You really wouldn’t want to be in the European Central Bank’s shoes right now. It is stepping through a minefield, tiptoeing between perilous politics, conflicting economic signals and deep divisions about where euro zone monetary policy should be heading.
There is little consensus other than for the ECB to play safe and stick policy in neutral gear over the next six months, while Europe tussles with critical national elections in Germany, France and Holland, which could carry grave risks for the future of the euro and a united Europe.
But the ECB keeping its head down and ‘playing politics’ may be a step too far for Europe’s monetary hawks. Policy hardliners in Germany’s Bundesbank are already fretting that Europe has had too much policy zest in the last few years and the excess stimulus now needs mopping up.
In their view, the ECB has ended up ‘behind the curve’ and signs of overheating in Europe’s bond and equity markets poses even bigger risks to the real economy. With the ECB committed to extending its €2.3 trillion asset purchase programme until December and key interest rates stuck in negative territory, it smacks of policy overload and a potentially nasty inflation backlash ahead.
ECB policy doves still read too many dark signs in the euro zone economy as a reason for maintaining the policy slack for years to come. Germany might be bouncing back to better health, but the 7.4 per cent collapse in German factory orders last month highlights a danger that things might not be going quite so well in Europe and the rest of the world.
Weaker European economies are still struggling as balance sheet restructuring and budget austerity continue to take their toll. Economic confidence surveys may be showing more optimism, but resilience is the key. For a generation in Europe used to zero and negative interest rates, higher borrowing costs will come as a shock. Europe could easily slip back into recession, wasting all the ECB’s reflation efforts.
Clearly, the power struggle has already begun and battle lines are being drawn. For investors, it could be a really rough ride as the whispering campaign kicked off last week with market rumours suggesting the ECB has already been discussing the possibility of an interest rate rise before the quantitative easing programme terminates at the end of the year.
Whether it was true or false, the rumour’s impact was cathartic, with investors ditching safe haven German government bonds en masse, sending yields higher and ramping up the euro in the process. The ECB might have slipped into neutral gear for now, but the ‘loose talk’ has already triggered the market into ‘tightening by proxy’. It is not going to be the last time either.
ECB hawks simply need to ‘lean with the wind’ to get the desired effect, in order to move interest rates and safe haven German bund yields out of negative territory and to ‘toughen up’ the single currency at the same time. Opportunities are bound to emerge, especially as Europe negotiates all the potential risk hurdles, through the French presidential polls in April and May and the German general election in September.
There have been glimmers of hope over the French elections recently, with indications that far-right National Front presidential contender Marine Le Pen will crash out in the second round of voting in May. And with a survey last week suggesting 75 per cent of French voters would prefer to keep the euro, it is no surprise market fears about France quitting the currency have subsequently eased.
If all goes well in the next six months and Europe comes through all these pressure points reasonably unscathed, the ECB should be ready to strike with higher rates from October onwards. Possibly one hike in the final quarter, leading to multiple rate hikes in 2018, with a view to closing the door to negative rates as soon as possible.
There is nothing inconsistent about higher euro zone interest rates happening at the same time as the ECB is still flooding the market with extra cash via quantitative easing. The liquidity is still needed to keep the financial and banking system well funded – imperative if euro zone recovery is to proceed successfully.
The road to higher euro interest rates will be a tough uphill battle but, if it is canny enough, the ECB can let the markets do most of the hard work.
David Brown is chief executive of New View Economics