European Central Banks Face Added Political Constraints

By Simon Nixon Features Dow Jones Newswires

Central bankers around the world are grappling with a common problem: when and how to normalize monetary policy at a time of normal levels of economic growth, normal levels of unemployment but abnormal levels of wage growth that is keeping inflation lower than their economic models predict.

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Policy makers at the European Central Bank and Bank of England are facing political challenges that are making their task even harder.

At the ECB, the political constraint is its own self-imposed rules setting limits on the size and scale of its quantitative easing program.

To avoid getting foul of the European Union treaty prohibition on direct financing of governments by the central bank, the ECB limits itself to buying government bonds strictly in proportion to each eurozone member's ECB shareholding and capping its ownership of any individual bond at 33%. As a result, its QE program will soon run into capacity constraints -- starting as soon as this summer with Germany, Spain, Ireland and Portugal. That leaves it little option but to taper its current EUR60 billion ($68 billion) monthly purchases next year, says Gilles Moec, senior European economist at Bank of America Merrill Lynch.

That's a problem, however, because the case for normalizing eurozone monetary policy is particularly weak, despite a recovery whose strength continues to take most economists by surprise. The economy has now expanded for 16 consecutive quarters, creating 6.4 million jobs. Consumer confidence is also at a 16-year high.

The sharp reduction in Eurozone political risks following the defeat of populist parties in recent elections in Austria, the Netherlands and France could lead to further upward surprises in growth it leads to a pickup in business confidence and investment. Yet unemployment in parts of the eurozone remains high -- suggesting substantial spare capacity -- wage increases are low even in Germany and inflation itself fell to 1.3% in June from 1.4% in May, well below the ECB's target of close to but below 2%.

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The ECB's challenge is therefore to construct a narrative that allows it to taper without provoking a taper tantrum that sends eurozone financing costs soaring and undermines the recovery.

Last week, ECB President Mario Draghi attempted to meet the challenge by declaring that "the threat of deflation has gone and reflationary forces are at play. As these reflationary forces emerge, the ECB can adjust the parameters of QE to offset an automatic real-terms loosening of monetary policy.

Balancing this subtle message was one that ECB would need to be "persistent" and "prudent" in maintaining highly accommodative monetary policy to support the recovery. The jump in eurozone-government bond yields last week, led by a sharp rise in German bund yields, suggests Mr. Draghi's rhetorical balancing act wasn't entirely successful.

The Bank of England's political difficulties are equally daunting.

On the face of it, the case for a tightening of monetary policy in the U.K. looks strong. Inflation is well above target at 2.9% and forecast to remain so beyond the BOE's two-year forecasting horizon. Inflation expectations have risen 0.4 percentage points since July. Unemployment is just 4.7%, and the economy is growing in line with its potential, helped by a growing global economy.

A recent hawkish speech by BOE chief economist Andrew Haldane, coming after three members of the BOE's rate-setting committee unexpectedly voted to raise bank rate in June, has fueled speculation the BOE could vote to raise rates later this year.

Yet hanging over the U.K. economy is the uncertainty of Brexit. Much of the rise in inflation is the result of the one-off devaluation of sterling after the 2016 referendum. The economy has proved remarkably resilient since the Brexit vote, thanks in large part to a surge in consumer spending to a 10-year high and accompanying collapse in household saving to a 50-year low.

Yet there are signs that falling real wages as result of higher inflation are starting to hurt consumer spending and confidence, which is reflected in falling retail sales, car registrations and house prices. At the same time, fears of a chaotic or badly managed Brexit that creates new barriers to EU trade may be deterring business spending. The U.K. economy grew by just 0.2% in the first quarter. Surveys suggest a subdued second quarter and start of the third.

That all points to the heightened risk of a premature normalization of monetary policy in the eurozone and UK.

Those risks could be heightened by action elsewhere. Should the Federal Reserve respond to a softening in recent data by delaying the three rate increases expected this year, a weaker dollar against the euro and sterling means an effective further tightening of euro-area and U.K. financing conditions. Both the euro and pound appreciated against the dollar last week.

That in turn highlights what may be the biggest challenge facing the ECB and BOE as they contemplate their plans for policy normalization: the need to reassure markets by explaining how they would respond if indeed they do make a mistake.

Write to Simon Nixon at simon.nixon@wsj.com

(END) Dow Jones Newswires

July 02, 2017 12:26 ET (16:26 GMT)