Search for policy flexibility poses dilemma for ECB
Our base forecast is that the ECB will extend QE by six months, but will modify forward guidance.
The European Central Bank (ECB) faces a communication dilemma ahead of its 8 December meeting. Amid growing evidence of a more robust recovery and improved policy transmission, there is a case for a reduction in the pace of asset purchases at some point in 2017. However, signalling an eventual tapering of asset purchases now would almost certainly trigger an unwarranted tightening of monetary conditions, akin to a ‘taper tantrum’, that might jeopardize the recovery and force the ECB to do more. The ECB has several options on the table and a compromise will undoubtedly be found. But, bottom line, we believe the ECB will want to avoid making a policy mistake so the risk/reward of a taper looks poor.
With core inflation so low, at 0.8% y-o-y in November, the ECB has no choice but to play it safe, especially as ECB staff forecasts are likely to be revised slightly lower for 2017-2018 (although the new 2019 projection should be consistent with inflation rising close to target by end-2019). We therefore continue to expect the ECB to extend its quantitative easing (QE) programme by six months, until September 2017, with the pace of monthly purchases remaining unchanged at EUR80 bn. However, this extension will likely come with a change in forward guidance in the form of a commitment to reassess the pace (and horizon) of asset purchases every quarter, based on progress on the inflation front.
The biggest risk to this scenario would be an 8 December announcement by the ECB of just a three-month extension of QE. Either way, we would still expect QE to continue with monthly asset purchases of EUR80 bn until Q4 2017 based on our forecast that core inflation will undershoot ECB staff projections.
Lastly, we expect the ECB to announce its intention to address the issue of scarcity of bonds it can acquire under existing criteria. The most effective option, in our view, would be to increase issue limits and allow for greater flexibility across countries (capped deviations from capital keys) and issuers (including agency and regional debt), extending the potential horizon of QE to mid-2018. Alternatively, a decision to remove the deposit yield floor cannot be ruled out.