Can the ECB Teach an Old Dog New Tricks?

The European Central Bank (ECB) has started unwinding its largest quantitative policy measure on record. While the process may seem clear, policy communications directed at investor behavior has been limited. What could that mean for the markets? Read on for our analysis.

In early 2014, the ECB began a major new policy, introducing negative rates and large-scale asset purchases in conjunction with more aggressive forward guidance on interest rates. The complementary policy pairing was designed to counter too-low inflation. Board member Benoît Cœuré said the ECB’s policy instruments were like the tail that wags the dog—the dog being long-term interest rates.[i]

At the time, one of the ECB’s problems was that term premiums were undesirably high, compensating investors for the possibility of rising rates. To help get expected future rates down, the ECB wanted term premiums to decline. This would mean lowering long-term yields on government bonds.

Nine years later — same dog, new tricks

In 2023, it appears the needed mix of measures and policy objectives has changed dramatically. Facing an environment of persistent above-target inflation, the ECB has begun shrinking its stock of balance sheet assets accumulated through the asset purchase programmes (APP).[ii] However unlike 2014, the nuance of signaling the ECB’s intentions for term premiums appears to be more complicated.

The ECB has not offered much in the way of prominent and explicit communications about the intent of its policy actions. However, we think opining on the importance of positive term premiums is an option the ECB may consider. In our view, it would be logical in light of its favorable opinion about the effectiveness of its asset programs.

If the ECB were to be explicit about its intentions, this would be quite a departure from other global central bank policy actions. For example, the Federal Reserve and other central banks have generally let balance sheet runoff occur more or less in the background, while instead emphasizing the importance of policy rates.

The conundrum — managing second derivative expectations

The ECB will likely want to avoid projecting an expectation of lower future policy rates. Even if it may cut rates in the future, we believe it needs to disabuse the market of certainty about this. For example, consider the unusual inversion of the German sovereign curve we’ve witnessed over the last several months. These market factors can be seen as implying lower rates in the future, which may concern the ECB. If the market simply expects rates to quickly come back down, the effect of rate rises on inflation control may be reduced.

Can this tail wag the dog? 

In many of its communications about the impact of asset purchases, the ECB has stressed that asset purchases worked in concert with negative rates and forward guidance. Presently, the ECB has new tools, notably options, to help protect the transmission of policy across countries. These tools are structured to enable the ECB to influence longer-term interest rates while mitigating the risk that they rise too high in some parts of the euro area. This is an important complement in our view. It may suggest a very different approach from 2014.

[i] https://www.ecb.europa.eu/press/key/date/2014/html/sp140413.en.html

[ii] https://www.ecb.europa.eu/press/pr/date/2022/html/ecb.mp221215~f3461d7b6e.en.html

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