Next week, the ECB is expected to extend QE into 2018 but to scale back monthly purchases
- The direction of the change may be clear but the extent isn’t
- The objective of QE has evolved. It is now a key instrument in providing guidance on the future evolution of policy rates
Next week’s Governing Council meeting hasn’t been so important for quite a while. Firstly because of Mario Draghi’s promise back in September that the bulk of the decisions with respect to QE would be taken in October. Secondly, economic growth is robust and leading indicators of inflation like input prices or supplier delivery times suggest some upward pressure is building. Hawks could use this as an argument to advocate a big reduction in monthly purchases and only a limited extension. Finally, the somewhat softer euro following slightly more hawkish comments from the Fed gives the ECB more leeway.
Two things seem clear: there will be an extension, but the monthly volume will go down. On the extension, media have reported it could be as long as 9 months, but with a halving of the monthly volume to EUR 30 bn. Markets cheered and bond yields declined, much to the relief of the ECB one suspects. It then seems that the devil will be in the (important) details: will there be a tilt towards more corporate and less government bond purchases? This would make sense given the focus of investors when the ECB will run out of sovereign paper to buy in countries like Germany and could fuel expectations that the extension is not the last one. Could a significantly lower monthly volume create an impression that this is the last extension or, on the contrary, that it enables to continue for longer?
At first glance, one could argue that a small monthly volume is not that different from doing nothing so why continuing? The answer is nuanced. QE works via a portfolio rebalancing channel (pushing investors out of government bonds into riskier assets including outside the eurozone) and a signaling channel. At this stage, the former channel hardly plays a role any longer, even more so if the monthly purchases were to be scaled back significantly. The latter channel however is all the more important so as to avoid that markets would price in a rate hike too early. QE has thus become a means to reinforce ECB forward guidance: “rates are to remain at present levels for an extended period of time, and well past the horizon of the net asset purchases”. The literature on forward guidance differentiates between Delphic and Odyssean guidance. Under the former there is no commitment for a certain course of action. The guidance is about expected macroeconomic developments and what this would entail for monetary policy. Under the latter, the central bank commits to a particular course of action. To this taxonomy we can now add “Frankfurter guidance”: using QE as a way of conveying that rates will be kept unchanged thereby avoiding the obligation to exactly define what “well past” means.