Threat of fiscal dominance

 (Photo: NN Investment Partners)

(Photo: NN Investment Partners)

Since the start of the year the ECB has faced increased nominal growth uncertainty. For a central bank that does not face the complications of an incomplete monetary union, this would be a reason to adopt a wait-and-see approach. This is all the more so because the ECB is standing with its back close to the wall.

The room for additional easing is pretty limited, which means the ECB should err on the side of tightening too little too late.

On top of this, investor focus has been very much on the QE instrument, which the ECB has used as the active policy lever in response to changes in the macro outlook. Closing the door entirely on this instrument will create a political hurdle to open it again, a much bigger one than the hurdle of ramping up the pace and/or duration of asset purchases when the program is still ongoing.

These considerations, coupled with the fact that the “Italian job” only added to nominal growth uncertainty, in themselves argue for extending the wait-and-see approach. Still, there is another side to this issue, which is the threat of fiscal dominance. An important potential cost of extending QE is that the ECB could be seen as enlarging the moral hazard problem by keeping policy easier than would otherwise be the case in response to a government that deliberately breaks the rules.

The ECB is thus faced with a devilish trade-off between running the risk of further underperformance in fulfilling its price stability mandate and accepting the kind of fiscal dominance that can set a dangerous precedent. ECB Chief Economist Peter Praet’s speech last week suggests that the ECB has made a clear choice in this trade-off in favour of not accepting any further increase in fiscal dominance. In that case it is of course important to send this signal early on, well before any renewed market turmoil surrounding Italy could start. The crucial date here is 20 September because that is when the Italian budget will be presented. In his speech Praet strongly suggested that the ECB now has sufficient confidence in the convergence of inflation towards the target. In this respect, he specifically referred to the underlying strength in the economy and the fact that this is increasingly affecting wage formation. He also pointed to the resilience of inflation expectations in the face of an increasing probability of an end to QE.

Our degree of confidence in inflation convergence is less strong than expressed by the ECB. It is still an open question how much a moderate acceleration in wage growth accompanied by a moderate productivity growth improvement will translate into higher core inflation. On top of this, we are still concerned that the actual underlying level of inflation expectations has slipped below target.

Our base case it thus now that next week, a taper will be announced that will bring net asset purchases towards zero between September and December. In our view this amounts to a hawkish shift in the ECB reaction function driven by the understandable need to avoid further fiscal dominance. As such, the rise in Bund yields since Praet’s speech makes sense to us. To be sure, a taper is not yet a complete given. There is still an outside risk however that the ECB will try to strike a better trade-off between insufficient confidence and the risk of fiscal dominance by announcing a taper to, say, EUR 10 billion per month for three months and signalling its “expectation” that this will be the final QE batch. In ECB parlance, “expectation” is less strong than “intention”.

A final interesting question is then whether or not the ECB will simultaneously transfer policy endogeneity to rate guidance and try to put a lot of dovish foam on the runway when doing so to prevent financial conditions from tightening. Ideally this should happen simultaneously, but Praet suggested that the ECB may not be ready to do this yet when he said, “Our policy guidance on rates will then have to be further specified and calibrated”.

Praet is a well-known dove. As chief economist he will put the policy proposal on the table and will thus have consulted many of his colleagues on this matter.

Still we would argue that there is some degree of uncertainty here, so if it becomes a fact, the market could still react. Secondly, and more importantly, there is a real risk that there will be no offsetting dovish rate guidance. Many market participants may not fully have this on their radar screens yet.

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