ECB curbs bond-buying in first step towards end of easy money

By Balazs Koranyi, Francesco Canepa Europe Reuters

The headquarters of the European Central Bank (ECB) are pictured in Frankfurt, Germany September 8, 2016. REUTERS/Ralph Orlowski (Copyright Reuters 2017)

FRANKFURT, Oct 26 (Reuters) - The European Central Bank, taking its biggest step yet in weaning the euro zone economy off years of stimulus, announced on Thursday it was cutting back on its lavish monthly purchase of euro zone bonds.

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Hedging its bets, however, it also extended the bond-buying programme's lifespan.

The bank cut bond buys in half to 30 billion euros a month, taking comfort in an economic recovery now in its fifth year and moving in sync with peers like the U.S. Federal Reserve and the Bank of England, as they also prepare to tighten policy.

Yet, the ECB remains bothered by low inflation, so it twinned the cut with a nine month extension of the programme, opting to buy fewer bonds but for a longer period to reassure investors it will provide accommodation for a long time.

Indeed, the ECB even maintained its option to increase or extend the bond buying programme, an apparent victory for policy doves who argued that they should not commit to ending the buys since possible euro gains could exacerbate weak inflation.

Designed nearly three years ago to fight off the threat of deflation, the bond purchase scheme has cut funding costs, revived borrowing and lifted growth, even if it ultimately failed to raise inflation back to the ECB's target of almost 2 percent.

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"If the outlook becomes less favourable, or if financial conditions become inconsistent with further progress towards a sustained adjustment in the path of inflation, the Governing Council stands ready to increase the asset purchase programme in terms of size and/or duration," the ECB said in a statement.

The ECB added that its main refinancing operations and the three-month longer-term refinancing operations will continue to be conducted as fixed rate tender procedures with full allotment for as long as necessary, and at least until the end of the last reserve maintenance period of 2019.

Interest rates were left unchanged as expected and the ECB reaffirmed its guidance to keep them unchanged until well after its bond buys end.

Analysts ahead of the meeting expected the bond purchases extended by six months at 40 billion euros per month while sources close to the discussion said that the internal debate was focusing on a nine month extension with volumes cut to somewhere between 25 billion and 40 billion euros.

Attention now turns to ECB President Mario Draghi's 1230 GMT news conference, where he is likely provide further clues about the bank's policy shift.

 

DEBATE

Hawks such as Germany and the Netherlands wanted a commitment to end bond buys arguing that growth is now above trend and that more purchases do next to nothing for inflation. Doves on the bloc's periphery meanwhile warned that a rapid exit could tighten financial conditions, undoing years of work.

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The broader outlook is as good as it has been since before the global financial crisis. An unbroken growth streak has created seven million jobs and the expansion is now self-sustaining, driven by domestic consumption.

Banks are better capitalised, lending is growing, and divergence between the core and the periphery, the biggest failure of the currency project, appears to have halted.

Inflation, however, is expected to miss the ECB's target of almost 2 percent at least through the decade as labour market slack remains large, keeping a lid on wages and supporting the case for continued support.

The ECB is also slowly running out of bonds to buy in some countries, suggesting that market constraints will play an increasingly large role in the policy debate as a major redesign of rules risked sending the wrong signal when the bank is working on an exit strategy.

While a nine-month extension at a reduced pace was seen as viable under current rules, another extension could require more creativity as the ECB would be running low on German bonds to buy, a hurdle since purchase need to match the so called capital key, each country's relative size in the euro zone.

To pave the way for the eventual end of bond buys, Draghi is expected to increase the emphasis on conventional tools, such as interest rates, which are not seen rising until 2019, at the earliest.

He is also seen focusing more on reinvestments from maturing debt and the support provided by its oversized balance sheet, shifting communication away from flows.

It could also take some pressure off government bond purchases by increasing the share of corporate and covered bond buys in the scheme, funnelling a bigger share of its cash to the private sector rather than government bond markets.

(Reporting by Balazs Koranyi and Francesco Canepa Editing by Jeremy Gaunt)

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