The European Central Bank is walking a tightrope as it prepares for its most momentous decision in years: How to wind down its giant bond-buying program without derailing the eurozone's economic recovery.
With the region's economy finally showing some vigor after years of painfully slow growth and political tensions there fading, ECB President Mario Draghi is expected to signal as soon as Thursday's policy meeting that the bank will start winding down its EUR2.3-trillion ($2.7-trillion) stimulus program, known as quantitative easing or QE.
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It isn't entirely clear yet whether Mr. Draghi will send that message on Thursday or do so in October. Either way, ECB officials have indicated that the QE program would continue for another few months and be phased out by the middle of 2018.
Investors are on edge, ready to unload eurozone government bonds and buy the euro currency as soon as the central bank clearly signals the retreat is coming.
ECB officials have given no fresh policy signals since late June, when Mr. Draghi roiled financial markets by suggesting in Sintra, Portugal, that QE's days might be numbered, noting that less stimulus would be needed as the economy accelerates.
The ECB's stimulus policy "does not fit at the moment with the state of the economy," said Claudia Broyer, an economist with Allianz in Frankfurt. She expects QE, currently running at EUR60 billion a month, to come to an end by the middle of next year.
The hypersensitivity of financial markets is making ECB officials cautious, however, and could delay their exit plans. They are eager to avoid repeating the policy error four years ago of the Federal Reserve, which triggered a sharp rise in U.S. government bond yields when it announced its own withdrawal from QE.
Even before the ECB has clearly signaled its intentions , the euro has been surging, rising more than 12% against the dollar over the past five months. As growth has strengthened, the prospect of political upheaval in the eurozone has eased with the early May victory in the French presidential election of centrist Emmanuel Macron over far-right candidate Marine Le Pen.
A strong euro complicates the ECB's job because it makes the region's exports more expensive in world markets and reduces the price of imports, weighing on economic growth and inflation.
ECB officials "have really been wrong-footed" by the euro's recent rise, said Martin Lück, chief German strategist at BlackRock in Frankfurt.
Another headache is the Fed, which holds its own policy meeting in two weeks. The euro's rise against the dollar partly reflects investors' belief that the Fed won't raise interest rates as aggressively as they once thought. U.S. inflation has softened unexpectedly, and President Donald Trump seems less likely to push through bold spending plans that might require tighter monetary policy.
The ECB "clearly expected the new U.S. government to do more in terms of economic expansion, which would have made the exchange rate less of a worry," said Mr. Lück.
Eurozone inflation remains weak. It rose to 1.5% in August from 1.3% the previous month, but is unlikely to move much higher over the next two years, echoing weakness in the U.S. and Japan. Some analysts think the ECB shouldn't move until inflation is closer to its target of just below 2%.
But pressure is building on the ECB to shift course.
In Germany, Europe's largest economy, the ECB's easy-money policies are a hot topic in national elections, scheduled for Sept. 24. In a televised debate on Monday, Alice Weidel, lead candidate for the far-right Alternative for Germany party, attacked the ECB's policies for fueling higher housing costs in Germany.
Last month Germany's top court indicated that QE might violate German law, although it ultimately kicked the decision up to the EU's highest court, the European Court of Justice in Luxembourg.
Crucially, after 2 1/2 years and multiple extensions, QE may soon run out of bonds to buy, thanks to the ECB's self-imposed constraints on asset purchases. The pool of assets could be expanded, but doing so would likely heighten political objections to the policy.
The bank's latest set of staff economic forecasts, published on Thursday, could offer the ECB an occasion to signal a change of course -- especially if the forecasts are strong.
Some economists are sanguine about the euro's recent rise, which they argue mostly reflects renewed economic vigor. At $1.19, the euro remains undervalued against the dollar according to calculations by the Organization for Economic Cooperation and Development, which puts the currency's fair value at around $1.29.
"A stronger euro is rather the result of the euro-area recovery, and not a major issue for ECB decision," said Marcel Fratzscher, a former ECB official who is now president of the German Institute for Economic Research, a Berlin think tank.
While a stronger currency might not harm German engineering companies, which sell highly specialized products, the same might not be true for Spanish farmers, for instance.
"What is important for the ECB is not the level of the exchange rate but the change in a certain period," Mr. Lück said. "The change since the start of the year is quite significant and clearly weighs on inflation."
Write to Tom Fairless at firstname.lastname@example.org
(END) Dow Jones Newswires
September 05, 2017 13:36 ET (17:36 GMT)