In a recent monetary policy meeting held in Frankfurt, the European Central Bank (ECB) kept interest rates unchanged while keeping the bond buying at a run rate of 60 billion euros ($72.2 billion) per month. Subdued inflation and an uncertain exchange rate are the primary reasons for the continued expansionary stance of the ECB.
Interest rates are expected to remain at the current level for an extended period of time. Regarding quantitative easing, bond buying will continue at the pace of 60 billion euros until the end of 2017, or beyond if necessary. Reinvestment of principal from maturing securities is also not being curtailed.
The medium-term outlook for inflation and growth remains unchanged for the eurozone. Despite strong economic growth, inflation lagged behind the target rate. Inflation ticked up slightly in recent months, but remained at restrained levels overall. In short, economic growth is translating into inflation gains rather slowly.
GDP growth is improving
Economic growth in the eurozone looks stable with GDP expected to grow 2.2% and 1.8% in 2017 and 2018. Compared to the June 2017 projection, GDP growth has been revised upward by the ECB in the current outlook.
Economic growth is being supported by the expansionary monetary policy, according to the ECB. Quantitative easing is resulting in favorable financing conditions along with facilitating deleveraging, which in turn is resulting in corporate profitability, employment gains and demand growth.
The ECB’s statement should be analyzed with caution, however. Once tapering starts, leverage problems will come back for financial institutions and corporations using the expansionary policy for deleveraging. Further, financing can become a problem once the taper starts. As a result, economic growth ignited through monetary expansion will have some repercussions when reversal kicks in.
Inflation stays under pressure
The ECB expects headline inflation to decline during the last part of the year. Improvement is yet to be seen in measures of underlying inflation.
Annual HICP inflation is expected to be around 1.5% and 1.2% for 2017 and 2018, according to ECB Staff projections. It is important to note the inflation projection has been revised downward compared to the June forecast on inflation. The downward revision was primarily caused by the appreciation of the euro. Mario Draghi, president of the ECB, had the following to say at the press conference.
“While the ongoing economic expansion provides confidence that inflation will gradually head to levels in line with our inflation aim, it has yet to translate sufficiently into stronger inflation dynamics.”
To review, inflation remains under pressure, which is not surprising, as policy expansion measures across the globe are not affecting inflation much. In the U.S., the Federal Reserve’s aggressive quantitative easing programs have been unable to bring the inflation to the target level. The eurozone is mimicking the same outcome.
One of the reasons for this might be the channeling of expansionary money towards the financial asset markets. The effect of expansionary policy isn’t affecting the grass-root level of the economy. That’s why we see inflated financial assets across the board, but no effect on inflation.
What’s the outlook for further monetary expansion?
At the moment, GDP is growing but inflation is consistently failing to hit the required levels. The ECB believes inflation is on an upward trajectory based on a medium-term outlook. But until the inflation target is met, the bank will be reluctant to start the tapering process. Draghi was quite clear about that at the press conference:
“We confirm that our net asset purchases, at the current monthly pace of 60 billion euros, are intended to run until the end of December 2017, or beyond, if necessary, and in any case until the Governing Council sees a sustained adjustment in the path of inflation consistent with its inflation aim.”
He further noted"
“A cross-check of the outcome of the economic analysis with the signals coming from the monetary analysis confirmed the need for a continued very substantial degree of monetary accommodation to secure a sustained return of inflation rates towards levels that are below, but close to, 2%.”
Some might argue downward revision in inflation was caused by the strengthening of the euro, and the ECB will start to taper soon. The problem is the bank itself is not sure. Uncertainty created by the appreciation of the euro will hold the ECB from reducing its balance sheet. Answering a question about exchange rate, Draghi said:
“It's so important that the medium-term outlook for inflation was revised downward in the staff projections mainly due to the appreciation of the exchange rate, which means that we will have to take into account this element in our information set in our future policy decisions.”
The point is uncertainty is there. The ECB is not going to taper unless the inflation target is met and economic growth remains on track.
Final thoughts
The ECB’s current press conference was the same tantrum all over again. Growth is healthy, but inflation remains subdued. Hence, the sentiment was dovish. Low inflation will keep the ECB on its expansionary track. Reduction in the balance sheet, or tapering, is not  likely anytime soon as the ECB cited inflation concerns amid exchange rate uncertainty. In my view, tapering is unlikely and stock markets will continue to be fueled by the money from quantitative easing.
