ECB needs to be original on tapering
Central bank should normalise interest rates before ending bond purchases or risk market ructions
The Fed is on a clearly flagged path to reduce stimulus, with at least two more rate rises to go this year. But if normalisation was difficult to start for Janet Yellen, Mario Draghi faces three policy dilemmas that make a tightrope walk look easy.
The eurozone has consistently beaten growth expectations over the past quarters. Yet under the hood there is a two-speed recovery in growth and inflation among its members. Core countries are leading together with Ireland and Spain, who have been early on reforms — while France, Italy and Portugal remain behind. Armed with mostly one-size-fits-all tools, the ECB will need extra skill to withdraw stimulus and keep the eurozone together.
The first dilemma is about timing. Normalising policy early can curb inflation where it is already rising, like in Germany or the Netherlands, but could also choke any recovery elsewhere.
The second dilemma is the trade-off between higher long-term yields versus keeping government borrowing costs in check. Current 10-year core yields, below 1 per cent, do not compensate for inflation, expected to be around 1.5 per cent over the same horizon. Tapering bond purchases further can help savers to meet their pension goals and revive banks’ profitability, but it can also make it more expensive for governments to borrow, penalising public spending and investment.
The third dilemma is about short-term rates, currently still negative at -0.4 per cent. While negative rates have kept the euro low and helped to boost exports, they also hinder bank profitability and lending activity even more than low long-term yields. The ECB has been trying to compensate for this collateral damage by paying banks to borrow under its TLTRO loans — the last of which was issued in March — but with scarce results.
Today, the consensus is for the ECB to follow the same normalisation path as the Fed: tapering bond purchases later this year or next and bringing interest rates back to zero only after that. This sequence worked well in the US. We believe Europe needs a different course: bringing rates back to zero before the end of tapering.
The ECB weighs its bond purchases following the share of capital contributions of its eurozone members, the so-called capital key. This means it buys more bonds from larger economies such as Germany and France, not the ones with the most debt outstanding. The result is that core debt has become so scarce that investors are hoarding it, pushing its yields even lower than the central bank’s overnight deposit rate. Investors pay -0.75 per cent to lock cash in German two-year notes.
Tapering QE would normalise long-end yields to more reasonable levels, but it wouldn’t solve the scarcity problem. It could also exacerbate the gap in core-periphery spreads, potentially leaving Italy or Portugal above sustainable funding levels: we estimate that Italy would need a steady 2 per cent nominal growth rate to make up for 3.5 per cent funding costs over the next decade. This means that a 2 per cent 10-year Italy-Germany spread would be barely sustainable.
A better alternative would be to taper while at the same time buying more periphery debt as well as making more collateral available in the repo market to reduce hoarding of core debt.
As for short-term rates, the longer the ECB leaves them in negative territory, the more it depresses bank lending. Bank loans account for nearly 90 per cent of corporate funding in Europe and small businesses, which generate 80 per cent of jobs, rely mostly on banks. This means the central bank should look at credit, not monetary aggregates to judge a successful transmission of its stimulus. Corporate loans have stabilised, but they aren’t growing.
For these reasons, we think the ECB should normalise interest rates before ending bond purchases. This is the best policy option for financial stability. It is also the most challenging. To do it, the central bank would have to justify a delay or an adjustment in tapering, acknowledging that some countries need more support than others. This may sound unpopular in Germany, where elections are approaching, but it is the right long-term decision.
In his latest press conference, Mr Draghi repeated the standard statement saying that policy rates are likely to remain low beyond the end of QE. But some in the ECB governing council are pointing in a different direction: Ewald Nowotny recently said the central bank doesn’t have to follow the same normalisation sequence as the Fed, while Ignazio Visco said the time between the end of QE and rate hikes can be shortened.
To hang together, eurozone leaders need to make a number of difficult decisions. These include giving leeway to Greece over its debt, establishing a common budget for infrastructure and defence, and recognising that monetary policy needs to adapt to the different rates of growth of its members. Like in the past, the ECB will need to lead the way.
Alberto Gallo is partner at Algebris Investments and manager of the Algebris Macro Credit fund