European economic update – the stabilisers are coming off

This week, European Central Bank (ECB) chief Mario Draghi expressed a positive, confident outlook on the health of the European economy during a well delivered speech to the European Parliament on Monday.

In his address he outlined ECB plans to hold the benchmark refinancing rate at 0.0%, with the first-rate hike pencilled in for Summer 2019. The central bank also plans to half the current monthly Quantitative Easing (QE) bond buying programme, taking it from €30bn to €15bn of monthly purchases. This reduction takes place in the final quarter of 2018 with the intention of bringing the programme to end. At its conclusion the ECB will have purchased €2.3trn of bonds and Mario Draghi will also complete his Presidency; he leaves at the end of the year. Draghi reflected on what he believes has been a successful albeit unconventional programme. He suggests that the stimulus effect equates to a 1.9% boost to growth and inflation between 2016-2020.

It’s important to remind ourselves of the purpose behind using these monetary tools. The ECB’s ‘zero’ refinancing rate is the rate of interest the central bank charges European banks to acquire funds for lending on to business and individuals. By making funds available at no cost it incentivises banks to lend, and in turn helps support spending and investment in the economy. Central bank bond purchasing is different in its transmission. This is where central banks buy bonds from the market to increase the money supply (liquidity). This pushes down long-term borrowing costs and encourages risk taking by investors. The bond buying measures usually follows on from interest rate adjustments, especially in extreme scenarios because it adds more downward pressure onto borrowing costs.

The extreme scenario of course is the 2008 financial crisis. This led us into an extreme period of ultra-low interest rates and lax monetary policy relative to history. The ECB are now very aware of the consequences of inflation and they treat the tools they use with respect. Anyone following the ECB will note how they aim to prevent market hysteria by not shouting too loud or moving too fast.

From a market perspective the announcement bringing ZIRP (Zero Interest Rate Policy) to an end and calling time on buying bonds is a clear signal from the ECB they are confident that the intensive monetary stimulus programme has worked. Draghi described the policy as being “very effective”.

The chart below shows just how economic performance is broadly correlated with the 2015 QE intervention. In mid-2017 we can see how bond purchasing decreased when it became evident Europe was making a recovery.

ECB Bond Repurchases vs European Economic Growth

Source: Bloomberg, data as of July 2018

It may seem strange to set out an intention to raise rates in the face of potential trade wars (which we write about below). However, when growth is set sustainably this is exactly the time to start raising rates to prevent the economy overheating later and causing inflation to rise.

In the short term, inflation picking up moderately can be positive because in this case it reflects growth across the whole of the economy. Inflation is currently at 1.9% (CPI), up from 1.6% in May, but remains under control and slightly below the ECB’s target of 2%.

The ECB are not cutting the apron strings entirely. Whilst they are confident the economy is ready for monetary tightening they are cognisant of the risks involved. The financial system has very much been supported by the ECB’s actions for some time now and cynics fear that by taking the stabilisers off, the economy may fall over. They are aware of this and it explains their cautious attitude and actions; introducing tapering rather than stopping bond purchases straight away and signalling well in advance their intentions to raise interest rates by what is a very small amount.