ECB State of Play: Balancing Between Commitment, Flexibility

By Christian Vits

     FRANKFURT (MNI) - European Central Bank President Mario Draghi will try to

pull-off a tricky balancing act at Thursday's press conference following the

Governing Council meeting, by setting out in detail how the ECB will reduce its

asset purchases while also trying to meet the more dovish Governing council

members' pleas for flexibility should price pressures abate. 

     Observers' central expectation is for the ECB to extend the QE programme

for nine months and to halve monthly purchases from Euro 60 billion to Euro 30

billion, effective from the start of 2018, with forecasts ranging from a

reduction of Euro 20 to 40 billion and for an extension of between six and

twelve months. Any compromise Draghi attempts will be complicated by hawks'

demands that the ECB commits to terminating QE whenever the extension ends and

doves' desire to leave open the option of extending it further.

     While none of the scenarios can be ruled out, several arguments speak for

the baseline scenario.

     The size of the cut in asset purchases and the duration of the extension

are tricky to predict in part because of the trade-off over flexibility. Hawks'

might be prepared to accept a nine-month extension in return for a commitment to

bring QE to a close, while doves might accept a shorter extension if options are

left open at the end.

     A meagre reduction in purchases might damage the ECB's perceived

determination to execute a convincing exit from its quantitative easing

measures, given favourable economic developments. The bond buying program also

faces constraints from the bank's 33 percent issuer limit and the scarcity of

assets available to buy next year.

     "We have to include these constraints in our recalibration," Governing

Council member Jan Smets said in an exclusive interview with MNI published Oct

11. 

     The longer the ECB wants to go on buying, the lower the monthly purchase

amounts should be.

     On the same day, ECB Chief Economist Peter Praet expressed sympathy with a

lower pace of purchases "in exchange" for a longer extension of the plan.

     "In more normal market conditions, the market's capacity to engage in

inter-temporal arbitrage improves. Consequently, investors may become more

patient, or, in other words, better able to evaluate the stimulus that can be

expected to come from a purchase plan that is to be executed over a more

extended time interval," he said.

     From the viewpoint of the more hawkish Council members the robust recovery,

with 17 consecutive quarters of economic growth, suggests bringing to an end to

the expansion of the central bank's balance sheet.

     "I think it is time next year to gradually but completely roll back net

purchases of bonds," Executive Board member Sabine Lautenschlaeger said on Oct

9. 

     "Even if we allow our net purchases to come to an end, monetary policy will

remain expansive. This is because we reinvest all the money from maturing bonds.

On top of that, our standard monetary policy measures would continue to have an

effect as well," she said.

     However, Draghi announcing a clear endpoint for the asset purchase program

seems less likely as inflation hovers well below the ECB's target of "below but

close to" two percent and is expected to temporarily decline towards the turn of

the year, reflecting base effects in energy prices. Domestic cost pressures from

labour markets are still subdued.

     What's more, the central bank has long claimed to stand ready to increase

its program "in terms of size and/or duration", if the outlook becomes less

favourable or financial conditions become inconsistent with a sustained

adjustment in the path of inflation.

     The euro's exchange rate adds another risk on top. With the Fed now

starting to shrink its balance sheet Draghi would risk neutralising the benefits

of the downward pressure on the euro by clearly signalling the end of ECB

balance sheet expansion.

     It is unclear whether the ECB will unveil full details of its purchase

program, such as the composition of bond buys, whether the proportion of German

bond-buying may change or whether the bank might reduce government bond

purchases in favour of corporate bonds. Decisions in this respect could be

postponed to December.

     Whatever the plan will look like, Draghi will most likely reiterate his

forward guidance and commit to a long period of unchanged interest rates,

underlining that interest rates will stay at present levels "for an extended

period of time" and "well past" the horizon of net asset purchases. 

     Given a nine-month extension of asset purchases to September next year that

would defer the first interest rate hike well into 2019.

     "We are confident as the conditions will continue to improve, the inflation

rate will converge in a self-sustained manner to our objective," Draghi stressed

in Washington on Oct 14. "But we should also be patient, because it is going to

take time."

     Still, patience also bears risks as the ECB has already used up a lot of

its ammunition and policy options appear limited should risks to its economic

baseline scenario materialise.

--MNI Frankfurt Bureau; +49 69 97782671; email: christian.vits@marketnews.com