Where There Is No Will, There Is No Way, and There Is No Will in Frankfurt

May 3 2017

“Incoming data since our meeting in early March confirm that the cyclical recovery of the euro area economy is becoming increasingly solid and that downside risks have further diminished.”

That were the lines that Mario Draghi, president of the European Central Bank (ECB), read after the meeting of the central bank’s board a few days ago. Draghi appeared more at ease than ever. And that is no miracle. Companies are investing more, households are deleveraging, declining unemployment is resulting in higher disposable income for the average Eurozone citizen which helps him to, optimistic as ever, not only wish for more, but spend more. Annual inflation also remains between 1.5 and 2 percent, exactly where the ECB wants it.

Either way, the ECB-board, led by Draghi, does not seem to alter its monetary course. The official rate remains at 0 percent and the pace at which the bank purchases corporate and governments bond in the Eurozone is also left unchanged. Whenever circumstances ask for it, the bank indicated that it stands ready to expand monetary policy even further in the coming time.

During a press conference after the meetings, a few comments were made that allow us to visualize what kind of policy we can expect from Frankfurt later this and next year.

Among other things, the ECB-president remarked that a possible exit strategy has not been discussed during the meeting, or even the question how the ECB should abandon the current monetary constellation, when to do so, and at what pace to carry out the operation.

The Revelation

The board underlined once again that it is ready to expand its purchase program, both in size and duration, in case Eurozone inflation expectations go south. These are all clear indications that the ECB is in no hurry to alter its monetary course.

And then there was an important announcement by Draghi about the nature of the debates among the ECB board members, a revelation that is paramount to getting a grip on the course that the ECB will pursue in 2017, 2018 and perhaps even 2019.

Draghi said some ECB board members, who thought that the recent, more optimistic data on economic growth came out so strong, are arguing that the ECB should come out way more optimistic than it currently does. From these statements, one might infer that pressures are building within the board to taper the purchases of government and corporate bonds and raise the official rate earlier than the market expects. But, as Draghi was quick to add, such disagreements arose in discussions on economic growth. On inflation, almost all board members were fully agreeing with each other.

And that is an important piece of information, since the board after careful weighing takes decisions based on inflation forecasts and expectations. Economic growth is, of course, important, but only partly as a component of the general picture on inflation in the monetary union.

What does the above mean, concretely, also if we would place all these factors on an imaginary timeline?

No Precipitate Action Is the Creed

The ECB’s purchase program will continue in 2017 and will in the most optimistic scenario be reduced gradually from January 2018 to end completely at the close of 2018. That is, if nothing happens in the meantime which could worsen the outlook for economic growth and, more important, inflation. If that were to happen, then we could easily expect a further tapering of the purchase program and eventually a complete halt to be postponed by at least a few months into the future. The outlook could worsen, for instance, if oil prices were to rise, the world economy would grow at a slower pace, or (geo)political upheaval emerges in the world, for instance due to tensions between the US and North Korea.

If developments in the world economy were to turn out more positively, and the economic recovery in the Eurozone were to gain a solid footing, even then we are not allowed to conclude that the odds of an earlier than expected tapering of quantitative easing and a first rate hike in years have increased. Many things indicate that the board is not very eager to make monetary policy less accommodative.

Not just the remark that a possible exit is not under discussion is a prove of this, the warning that the size and duration of quantitative easing could be increased is another clear prove. The other at least theoretically possible scenario – that the ECB decides to taper QE earlier – is not even mentioned! Add to that the fact that the ECB continues to say that the official rate “will remain at its current or a lower level for an extensive period and long after purchases of government and corporate bonds has ended” and it should be clear that the bank is not very keen on ending QE.

It would not be a surprise if the ECB in the course of the coming months becomes increasingly confident about the economic recovery. When the economists of the central bank present their new forecasts for economic growth and inflation in June, it should not surprise us when the board views risks for economic growth fairly balanced, that is, that it views the odds of better than expected developments as high as the odds of a disappointment (the ECB is currently still of the opinion that a disappointment is more likely). That does, however, not mean that the ECB will began preparations for a less expansionary monetary policy.

Savers and Investors Are Warned

The sequence of the steps to be taken in case of an exit is still: first, to stop quantitative easing and take a pause to see how the economy reacts and consequently, very carefully, begin talking about a forthcoming rate hike.

Ending QE is, in the most optimistic of scenarios, in the current circumstances to be expected somewhere in the second half of 2018. With a pause between that moment and the first rate hike (just as the Fed did in the US) the first rate hike by the ECB since 2011 is to be expected somewhere in the summer of 2019, if not later.

For a saver / investor with a long-term horizon, the above means at least two things. In the first place that savings do not only yield close to zero (after the tax authorities pays a visit and inflation is subtracted, real returns are even negative), but that this will continue to be the case for an extensive period. Let us imagine that the ECB increases rates in 2019. That will be most likely from 0 to 0.25 percent. The odds are high that rates on savings accounts will barely react to that. But the ECB will only raise rates when the bank is convinced that inflation is and will remain slightly below 2 percent. That, in turn, will only be the case when inflation remains at that point for a long time, since the ECB prefers to proceed with caution for some time. Taking everything together, it means that the real interest rate on savings accounts will be quite negative. And for the sake of simplicity I have ignored taxes for now.

In the second place the above means that stock market prices will continue to enjoy upward momentum. Economic growth is on the rise, while the money keeps flowing: better circumstances for stocks are hardly conceivable. But be warned: to the degree that monetary policy will remain ultra-loose for much longer, while the economy is finding its way out of the crisis zone, the risk of a terrible and sudden setback also increases, for instance when markets begin to perceive that in the near future such a perfect combination for stocks might come to a grinding halt. History teaches that a setback can be quick and relentless.

History also teaches us that central banks will then come to the rescue, with an expansion of monetary policy. And to conclude, economic history teaches us that this generally translates into an excellent outlook for precious metals.

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