Longer‑Term Risks Complicate ECB's Policy Path: Beware the Pillars of Hercules

by Andrew Bosomworth of PIMCO, 12/14/18

In his last press conference for 2018, European Central Bank (ECB) President Mario Draghi confirmed plans to stop net asset purchases at the end of the month and to reinvest principal from maturing bonds on its balance sheet. He also acknowledged the balance of risks to the ECB’s growth outlook is “moving to the downside” owing to a host of factors that have buffeted global markets in recent weeks. In the long term, these downside risks could have profound consequences for the economy, markets and investors globally. Will the ECB have sufficient firepower – and support from the population – to spur the economy when the next recession arrives?

Baseline growth and policy outlook

Eurozone growth largely depends on external demand, reflected in its large current account surplus (worth 3.1% of gross domestic product in the 12 months to September 2018). And with global growth likely to “synch lower” across the major economies in 2019, as PIMCO concluded following its recent Cyclical Forum, the risks to eurozone growth are mounting. Here’s our medium-term base case outlook:

If a pause in the Federal Reserve’s rate hiking cycle occurs in the first half of 2019, which looks likely, and the euro appreciates versus the U.S. dollar in response, the ECB’s path to policy normalization could be short-circuited.
Eurozone growth momentum should remain sufficiently strong in 2019 to enable the ECB to deliver a 15 basis point (bp) hike to the deposit facility rate late next year, taking it to −0.25%.
A narrow window of opportunity could arise in 2020: As global growth slows further, eurozone domestic demand may allow the ECB to deliver one, maybe two, 25 bp hikes, taking the deposit facility rate to 0% or 0.25%.

Longer-term risks

But in 2021 and beyond, the synchronized slowdown in global growth is likely to prompt the ECB to pause too, if it gets that far. Presumably the ECB learned from its late-cycle hikes of 2007, just before the last recession, and next time will be more cognizant of the global economy’s and financial markets’ interconnectedness. But what capacity will it have to ease monetary policy by then?

We expect that even in 2021 the ECB’s balance sheet will still be large, it will still be reinvesting maturing bonds from the current asset purchase programme and interest rates will not be far from zero, if at all.

In this plausible scenario, the ECB could fail to normalize its monetary policy stance before the next recession occurs. Asset purchase programs and negative interest rates would become a quasi-permanent fixture of the European financial landscape.

Consider in addition that Europe’s population is aging at a similar rate to Japan’s, just 10 to 15 years behind. Older societies tend to prefer lower inflation so as to maintain the real purchasing power of their savings. The ECB thus faces a non-insignificant risk that inflation expectations in the eurozone materially dislodge from 2% and that it cannot deliver the interest rate hikes discounted in forward curves.

Legend has it that the Pillars of Hercules rose from the sea as a warning to sailors to go no further because unknown risks lurked beyond. That lesson appears appropriate to the ECB today as it seeks a policy path forward amid myriad risks to growth. And for investors, these risks suggest caution, particularly in eurozone peripheral sovereigns and corporate credit.

Andrew Bosomworth is PIMCO’s head of portfolio management in Germany and a regular contributor to the PIMCO Blog.

© PIMCO

Longer‑Term Risks Complicate ECB's Policy Path: Beware the Pillars of Hercules

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