During recent months, the European economy has shown various signs that the economic recovery is on track. Headline inflation in the euro area ticked higher, ranging between 1.5 per cent and two per cent during the first four months of the year. Growth in euro area economies was of 0.5 per cent for the first quarter, beating the UK at 0.3 per cent and the US at an annualised rate of 0.7 per cent.
Unemployment in the euro area is at 9.5 per cent, the lowest level since 2010. Reported corporate earnings were also strong, beating analysts’ expectations by over 10 per cent, according to Goldman Sachs. Political risks seem to be receding following the victory of Emmanuel Macron in the French general election. Moreover, the European Commission has recently revised upwards its growth projections for 2017.
It therefore comes as no surprise that the market reacted with such glee to this positive momentum: very strong performance in European equities, a strengthening euro against the other major currencies and tighter credit spreads in the corporate bond market.
These effects are, to a large extent, the result of a successful ultra-accommodative monetary policy by the European Central Bank (ECB) in their efforts to lower borrowing costs and stimulate growth and inflation. Besides cutting the policy rate for the euro down to -0.40 per cent, they have, since 2015, injected a total of circa €1.9 trillion by buying government bonds (including Malta government bonds) and corporate bonds. These Quantitative Easing (QE) programmes are expected to continue running until the end of the year with a target pace of €60 billion of purchases per month.
The spotlight has now shifted back to the ECB and what they intend to do given the developments in the economy. Markets are carefully eyeing the next governing council meeting on monetary policy which will be held in Tallinn on June 8. But will the evidence of a recovering European economy be strong enough for the ECB to alter the monetary policy strategy for the eurozone?
There seems to be diverging views among executive board members on what the bank should communicate and how, particularly when markets are overly sensitive to perceived changes in the bank’s course of action. The conundrum for the ECB is to avoid doing too much too early or too little too late.
...moving too early towards a tighter policy could suffocate the positive momentum achieved so far
Maintaining status quo and avoiding any pre-commitments to policy changes leaves ECB President Mario Draghi with a high level of flexibility, in the case where downside risks in the euro area had to reappear. On the other hand, failing to acknowledge or provide guidance on the policy response to a recovering economy will reflect negatively on the bank’s credibility.
As the executive board member, Benoit Coeure, eloquently phrased it, “there’s always the temptation of gradualism in monetary policy. Too much gradualism in monetary policy bears the risk of larger market adjustments when the decision is eventually taken.”
The other side of the coin is acting hawkish and saying too much too soon. The QE programmes have been massaging the bond market for the last couple of years and, besides driving bond prices to historical high levels, these have inadvertently introduced an elevated sense of complacency and security in the asset class; a fragile state which could quickly turn into a bloodbath if there were any indications of an early unwinding of the programmes.
Aside from the adverse market reaction, Mr Draghi would be in a somewhat uncomfortable position which is difficult to reverse should the economy take a turn to the worse in the next few months. Not to mention that moving too early towards a tighter policy could suffocate the positive momentum achieved so far.
The only option left for Mr Draghi is to strike a diplomatic balance between coming across as neither too protective nor too aggressive in his discourse. What seems to be in store at the next ECB meeting is a mild shift towards a more positive tone with no material changes in monetary policy or forward guidance, yet.
What the ECB will likely be focusing on before effectively ‘pulling the plug’ are signs of resilience rather than recovery at this stage. The attention will shift towards wage growth, which is still very low despite the current level of unemployment, domestic investment and bank lending, as well as risks to the economy stemming from the external environment.
Matthias Busuttil is an investment advisor at Curmi & Partners Ltd.
The information presented in this commentary is solely provided for informational purposes and is not to be interpreted as investment advice, or to be used or considered as an offer or a solicitation to sell/buy or subscribe for any financial instruments, nor to constitute any advice or recommendation with respect to such financial instruments. Curmi and Partners Ltd is a member of the Malta Stock Exchange, and is licensed by the MFSA to conduct investment services business.