End of QE and First Rate Hikes Around the Corner in the Eurozone?

January 23 2018

Will the European Central Bank (ECB) raise interest rates – currently at zero percent – earlier than the market until recently was anticipating? A recent report led markets to speculate about an earlier rate hike. Is such speculation well-founded or do markets exaggerate once again?

To sponge up €30 billion euro in government and corporate debt until September 2018 and decide at the end of the summer or early autumn what the interest rate will be for the months and quarters afterwards. During that entire period, the official rate is to remain at zero percent. Only sometime late in 2019 will the central bank begin considering a rate hike. This was more or less the expected ECB policy for the current and next year. This scenario needed to be revised, according to the market.

The motive behind this revision is the recent publication of a summary of an ECB board meeting from December last year. The report states that the ECB could alter course for the remainder of this year and next year as soon as in a few weeks from now, in March.

Financial markets immediately translated this into “the ECB will stop buying government bonds sooner than expected and raise interest rates in March 2019.” The EUR/USD climbed to above 1.20 on the news. German long-term sovereign bond yields, particularly the five-year and ten-year rates, began increasing in anticipation of an earlier than expected end to the era of unconventional monetary policy in “Euroland.”

Before anything else: to expect that the ECB will tighten monetary policy earlier than expected is perfectly logical. After all, the central bank left monetary policy extremely loose for many years in order to boost inflation and economic growth in the Eurozone. This is something that has been achieved by now. The Eurozone economy is growing at almost three percent, the fastest annual growth since 2007, while the outlook for this and next year are positive. Inflation, almost completely absent a year ago, currently stands at about 1.5 percent and is expected to increase even further in the coming months. Nevertheless, the odds that the market’s expectation of an early tapering of QE and a first rate hike in years (a rate hike in the first quarter of 2019) is wrong, appear quite high.

Inflation Remains Too Low

In the first place, because it makes perfect sense that a substantial number of board members – some who were never in favor of zero percent interest rates and large-scale government bond purchases to begin with – feel supported by the recent strength in economic growth and inflation. Of course, last year we heard similar rumors, but at the time there were at most two lone monetary hawks, hardly anything that should lead investors to expect a significant reversal in the ECB’s monetary policy.

In the second place, because inflation is still too low according to ECB standards, even despite a recent rise. The central bank aims for an annual inflation rate of about two percent, accompanied by sufficient certainty that such an increase of the price level will be able to persist and continue at more or less the same rate. The current outlook is that inflation will rise further this year and next year, but even in that scenario the inflation rate will remain too low for the central bank. Moreover, such an increase is only to be expected if the ECB does not tighten the monetary reins. If the central bank tightens monetary policy, it is likely that inflation will drop again. And the current inflation rate is, I repeat, already too low for our European monetary knights. Putting downward pressure on inflation is about the last thing the ECB wants.

In the third place, because the report of the board meeting clearly indicates that the course of monetary policy will only be altered if growth and inflation continue to pick up. Whether that will happen and at what rate, remains to be seen in the coming months.

For the History Books

The ECB is clearly optimistic with regard to economic growth and inflation, which is understandable given recent developments. Consequently, it is to be expected that the central bank will gradually make monetary policy less expansive. But since everything is very uncertain at this point in time and since especially inflation seems to continue to remain more or less as low as now, a scenario in which the ECB will put a sudden halt to its quantitative easing (QE) program as soon as September seems rather unlikely. Just as unrealistic is, according to my judgment, the expectation that the central bank will begin raising rates in March 2019. That would only happen if the inflation rate rises unexpectedly fast in the Eurozone this year, and – crucially – if ECB forecasts will confirm a future inflation rate that significantly exceeds the annual two percent inflation rate target.

That said: my expectation is that the ECB embarked upon a path of increasingly less loose monetary policy. I would be surprised if the bank still purchases government bonds in March 2019. As far as rate hikes are concerned, I expect a first rate hike in September 2019. On the one hand, because the Eurozone will have had a grace period of half a year without QE and the ECB will, as a result, be able to judge how the economy is doing without the support of QE. On the other hand, because the current ECB Chairman Mario Draghi has to resign from the ECB in November. Given the economic outlook in the Eurozone and everything that I have learned in recent years about Mario Draghi and other European central bankers, I would not be surprised if he raises interest rates in September just to avoid becoming the first central banker in history (of a major central bank) that has not even once raised interest rates during its presidency.

Translating all this into perhaps something more familiar, it means that we should not be surprised if the EUR/USD drops over the next few months toward 1.10, something which could easily pull precious metals prices down.

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