The European Central Bank is expected to detail the first steps toward unwinding its $4.5 trillion balance sheet Thursday, nearly three years after it signaled the start of its controversial program of quantitative easing.
Officially known as the Public Sector Purchase Program, the ECB's version of QE has hoovered up more than €2 trillion ($2.36 trillion) eurozone government, agency and corporate bonds since March 2015, as part of the Bank's effort to stoke inflation in the region's then-moribund economy. The eurozone economy had been hammered by the after-effects of an almost existential debt crisis triggered by mounting deficits in Greece and Italy and bank collapses in Ireland, Cyprus and Spain.
It hasn't, however, had an enormous impact on currency area inflation -- the ECB's exclusive mandate -- and consumer prices remain puzzlingly subdued. In fact, despite a robust economy, falling unemployment, record high-German business confidence and the fastest rate of factory output prices in nearly seven years, eurozone inflation isn't expected to reach the ECB's "just below 2%" target until 2020 and currently sits at 1.5%.
That's put a great deal of pressure on ECB President Mario Draghi and his colleagues on the Bank's Governing Council, a group comprised of finance ministers from the 19 countries using the single currency as well as six appointed members known as the Executive Board. Below-target inflation should, given the Bank's mandate, demand a continuation of the E60 billion in monthly asset purchases that beats down risk-free yields and entices investment into the real economy. But with the equivalent of nearly 40% of eurozone GDP already monetized -- a figure that's nearly twice the equivalent of the Federal Reserve's purchases -- there's not a great deal of bonds left to buy. And, as the Federal Reserve's own research has shown, QE's "bang for the buck" diminishes over time.
Furthermore, with the Fed starting its long balance sheet unwind and the Bank of England teasing rates higher in order to combat Brexit-induced inflation, the ECB can't really afford to wait much longer amid a global shift in central bank policy.
But that also means Draghi & Co. need to be delicate. Cutting the pace of purchases too quickly could cause a quick spike in bond yields that upends regional equity markets and pressures government borrowing costs around the currency area periphery just as the long-awaited recovery is beginning to find traction. Cutting too slowly risks inflating asset bubbles -- particularly in housing and stocks -- and risks further accusations by critics of monetary financing of member state budgets, which is expressly prohibited under European law.
That's essentially led analysts to their "lower for longer" conclusion for Thursday's meeting, meaning the ECB will likely slash the pace of its monthly purchases in half, to €30 billion, but extend the timeframe past the "soft" December deadline into the middle of next year.
However, in a nod to the so-called "taper tantrum" of May 2013, and the need to maintain order in the grumpier segments of the bond market, ECB Chief Economist Peter Praet hinted earlier this month that the Bank will likely communicate plans to reinvest a portion of its maturing debt into new asset purchases, thus smoothing the effects of market disruption.
Not that there's a great deal of evidence that this is an issue: benchmark 10-year German bund yields, a proxy for risk-free government borrowing costs, have traded within a 30-basis point range for much of the second half of this year and are, in fact, some 10 basis points south of their July peak of 0.60%. The same is true for Italy, the world's third largest debtor, where benchmark 10-year yields are lower -- at 2.03% -- than they were in mid-June.
Placid government bond markets and a compelling economic recovery should provide more than enough cover for the ECB to cautiously reduce the amount of bonds it's taking from the market each month until it sees what Draghi has consistently referred to as a "sustainable" move toward the "just below 2%" inflation target. If and when that's achieved -- and it's certainly taking a lot longer than anyone anticipated -- the Bank can then accelerate the unwinding and move on to phase two of its normalization process: increasing interest rates.
That phase, however, is a long way off, particularly given the fact that the Bank is tied in to various programs designed to entice private bank lending in the real economy until the later part of next year -- programs that were designed to underscore its commitment to near-zero interest rates.
Thursday's signals are important, for sure, but they're only likely to be one in a series of slow and methodical steps the Bank will take on its path toward policy normalization and, ultimately, Draghi's own personal exit from Frankfurt when his eight-year term expires in November 2019.