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Key Takeaways (full report available here or here)

• We believe the ECB will follow the Fed's sequence of policy normalisation: taper first, raise rates later, and reduce the balance sheet last.
• But the timing will be different since the ECB's mandate focuses more on inflation, and the eurozone economic expansion is still in its infancy.
• The ECB will look at the output gap, inflation expectations, and the resilience of the eurozone economy before raising rates.
• We expect the first rate hike in Q3, 2019.
• The eurozone's greater dependence on bank financing and the longer lasting stock effect of the ECB's QE policy are likely to lead to a slow pace of rate hikes and balance sheet tightening.

The Fed's Blueprint for Sequencing

Tapering before raising rates makes sense, based on the interactions between quantitative easing (QE) and rates. Asset purchases not only ease financial conditions by compressing bond yields, but show a commitment to keeping rates low for longer, absent a zero lower bound in the eurozone. By first ending the asset purchase program, the ECB can break this link and signal future rate rises.

The next step will be to raise interest rates while operating with a stable balance sheet. The key reason why the Fed proceeded in this order also applies to the eurozone. While setting interest rate policy is straightforward, there is much uncertainty regarding the impact of unconventional monetary policy measures on financial conditions. Bringing interest rates higher allows the central bank some leeway to cut them if financial conditions tighten too much when it starts shedding assets (see Bernanke on "Shrinking the Fed's Balance Sheet" Brooking, 26 Jan 2017).

As a third step, the ECB will start reducing its balance sheet. We think it is important to do this in a passive manner to facilitate monetary policy communication. Therefore, like the Fed, the ECB will likely stop reinvesting maturing securities holdings, but not actively sell assets. In this way, balance sheet reduction is predictable. Markets can estimate the degree of policy tightening implied by the balance sheet reduction and draw conclusions on interest rate setting. From what we've observed in the U.S., this approach has helped prevent sudden tightening of financial conditions, in contrast to the "taper tantrum" of 2013.

Chart 1
 

  

The ECB's Timing Will Differ Due to the Inflation Target and the Economy

We don't believe the ECB's timeline for exiting expansionary policy will be the same as the Fed's. First, the Fed and the ECB have different mandates, the former targeting inflation and unemployment, the latter focusing more on inflation. The Fed had an explicit unemployment rate target to tighten policy, whereas the ECB is looking for a "self-sustained upward trend in inflation." Second, the ECB is dealing with an economic cycle that is in a very different phase. The U.S. economy is entering its 106th month of economic expansion, the third longest expansion since 1854. By contrast, the eurozone has only just recovered from the sovereign debt crisis.

 

We think that, as per its three criteria for normalisation: convergence, confidence and resilience, the ECB will focus on three variables to assess inflation dynamics and define the right time to raise rates.

Hysteresis: The ongoing slack in eurozone labour markets has been a hot topic in the ECB's governing council meetings. Because the region is recovering from a long crisis, there is considerable uncertainty regarding the output gap. During the protracted period of weak demand, firms delayed investment decisions, while labour market reforms have made it difficult to gauge structural unemployment. It's unclear, at least from models, whether this has translated into a permanent negative impact on the economy's growth potential (meaning, hysteresis) or whether we can expect stronger growth (see chart 2). For monetary policy setting, less slack means inflation is more likely to accelerate (see "The Eurozone Has Reached Cruising Altitude," published 28 March 2018, on RatingsDirect). In the ECB's case, this relationship is even more relevant than for the Fed, since the ECB does not use the concept of full employment as a second compass for setting rates.

Chart 2
 

  

Inflation expectations: A key finding in last year's Philip's curve debate is not only that it is alive and well, but also that inflation expectations are key determinants of inflation dynamics in the eurozone. They've been moving in the right direction over the past year but, at 1.7%, are still some way away from the ECB's inflation target (see chart 3). Since expectations are conditional on support from the current monetary policy, the ECB needs to be confident about the inflation outlook before changing its monetary policy stance. In this respect, we see that the Fed raised rates relatively slowly until 2017, when inflation expectations moved above its 2% target. A broad-based economic recovery: Adding to the complexity is that the ECB sets monetary policy for 19 countries. Thus, even if the output gap has closed for the eurozone as a whole, the ECB will still seek to secure the region's overall resilience, such that no single country or external shock can derail the recovery. Apart from a soft patch at the start of this year, the eurozone's economic expansion appears solid. External risks exist, such as the possibility of trade tariffs, faster than expected tightening of financial conditions in the U.S., and the strong euro. But for now, we don't think those risks will cause the ECB to change its course. We think that, by 2019, there will be enough evidence showing the eurozone output gap has closed. Inflationary pressures should then give way to higher inflation expectations, and we expect rate hikes will follow in the first half of 2019.

The Eurozone's Bank-Based Economy has Different Needs

The ECB will also need to consider differences in policy transmission before taking the Fed's way of normalising monetary policy. If the ECB started its QE program later than the Fed, it is because of the euro area's more bank-based financing structure (see chart 4) compared with that in the U.S.

The ECB's first use of Targeted Long-Term Refinancing Operations (see chart 5) were aimed at restoring the bank lending channel, allowing banks to borrow as much money as they needed. However, banks first had to repair their balance sheets, still largely affected by the sovereign crisis, before lending to the private sector or even to each other. In the end, this situation led the ECB to engage in active balance sheet management through QE. Looking ahead, the predominance of bank financing in the eurozone means that funding conditions are likely to become tighter after rate hikes than after balance sheet reduction. Wary of not repeating its 2011 policy mistake, and with high leverage in the region, the ECB will increase rates only gradually, in our view.

Aside from starting QE later than the Fed, the ECB also reduced rates further than the Fed, pushing them into negative territory. Estimates of the neutral rate suggest it is still negative or close to zero in the eurozone (see chart 6). This is another reason why it will likely take more time for the ECB to raise rates sufficiently to allow it to start reducing the size of its balance sheet.

Furthermore, QE is likely to have a more lasting effect on bond yields in the eurozone than in the U.S. The ECB's asset purchase program came at a time of fiscal consolidation in the eurozone, when debt issuance was lower than the ECB's purchases. This has significantly reduced the supply of long-term sovereign debt on the market, compressing yields relatively more than was the case in the U.S. We expect this stock effect will continue to weigh on yields when the ECB reinvests maturing securities, thus continuing to constrain the supply of European safe assets (see chart 7). This could favour a more gradual balance sheet reduction, since the ECB will want to avoid a strong rise in yield spreads. That said, we think this will be a secondary concern for the ECB because eurozone sovereigns are largely shielded from sudden rises in yields (see "Sovereign Debt 2018: Eurozone Sovereigns to Decrease Commercial Borrowing by 9% to EUR 850 billion In 2018," published 22 Feb 2018). The ECB's QE has helped governments reduce their debt-servicing costs and they've used the period of low interest rates to lengthen their debt-maturity profiles. For example, according to Deutsche Bank's estimates, the German sovereign saved about €260 billion (equivalent to 8% of 2008 GDP) from 2008 and 2016. Absent any external or domestic shocks, we think the ECB could start reducing its balance sheet from the end of 2020. Yet, what might complicate the ECB's task is that, by that time, other advanced economies (especially the U.S.) will have reached the end of the economic cycle, providing less external support to growth in the eurozone. To avoid being too pro-cyclical, the ECB might opt for slow balance sheet reduction.

Chart 3