ECB to Scale Down but Extend Bond-Buying Program -- Update

By Tom Fairless Features Dow Jones Newswires

The European Central Bank said Thursday that it will scale down its giant bond-buying program while extending it deep into 2018, in a keenly awaited move that sets the eurozone on a path toward higher interest rates as its long economic crisis recedes.

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In a policy statement, the ECB said it would continue to buy bonds through September 2018, but that the pace of its purchases would fall to EUR30 billion ($35 billion) a month from EUR60 billion after December this year. The bank also left its key interest rates unchanged.

The euro edged down 0.4% to $1.1764 from $1.1807 just ahead of the announcement, while yields on German 10-year bonds edged down to 0.444% % from 0.464%. Yields move inversely to prices. Eurozone stocks roughly doubled the day's gains to trade up 0.6%.

The decision treads a careful path between the ECB's growing confidence that the eurozone's economic recovery, now into its fifth year, can proceed with less support from Frankfurt, and concerns that inflation--the ECB's primary focus--remains too weak.

It is the third time that the ECB has extended its calendar for bond purchases, known as quantitative easing, or QE. The latest move will push the overall size of the program above EUR2.5 trillion, or almost a quarter of the region's economic output, and more than double its originally planned size.

Investors will now turn their attention to ECB President Mario Draghi's news conference at 08:30 ET, where he is likely to explain the rationale behind the bank's decision and could detail how it will overcome potential bond shortages.

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While the decision to extend QE was widely expected, the ECB threw in some sweeteners, including a promise to reinvest the proceeds of maturing bonds for "an extended period of time," and to lend freely to banks against collateral until the end of 2019.

The bank also left open the option to extend QE again, rather than announcing a fixed end-date. That decision gives the central bank flexibility to respond to future economic shocks, ahead of national elections in Italy and a possible change of leadership at the Federal Reserve. But it is likely to upset some ECB officials, who were keen to draw a line under QE.

The decision to scale down QE sets the ECB on the same policy path as the Fed, which started raising interest rates almost two years ago and is expected to announce another increase in December, its third this year.

Still, the ECB said it is some way from raising rates. It expects interest rates to remain at their current levels "well past" the end of QE, according to its policy statement. Most investors don't expect an ECB rate increase until spring 2019.

That should help to check any rise in eurozone bond yields or the euro currency. The euro has risen by around 12% against the dollar this year but has held steady since September, when ECB officials raised concerns about its strength. The euro remains weak by historical standards, helping to support the region's large exporters and contributing to record current-account surpluses.

The ECB's decision leaves little room for error. After the latest extension, the ECB will have exhausted the bonds that it is allowed to purchase under the current rules of QE. That raises questions about the ECB's ability to respond to any future crisis--notwithstanding the bank's stated willingness to scale up the program again if necessary.

Despite the ECB's caution, investors worry that higher borrowing costs could put pressure on the region's highly indebted households, private firms and governments, many of which have made little progress in paying down the debts accumulated during the recent financial crisis.

On the other hand, the extension of QE is likely to deepen concerns, particularly in Germany, about the harmful side effects of years of easy money. They include potential asset-price bubbles, lower returns for savers, and the misallocation of resources to nonviable "zombie" firms. Critics contend that such adverse side effects accumulate over time, even as the positive impact of QE diminishes.

Write to Tom Fairless at tom.fairless@wsj.com

(END) Dow Jones Newswires

October 26, 2017 08:28 ET (12:28 GMT)