Will central banks learn the lesson of the Fed’s 'taper tantrum'?
The European Central Bank (ECB) has a problem. The continent’s economy has been surviving, at least in part, on the monetary methadone that is Quantitative Easing (QE) since March 2015.
The massive bond-buying programme was deemed necessary just under three years ago to breathe life into the continent’s myriad economies and bring inflation close to the ECB’s target of 2%.
However, the central bank – like many of its contemporaries across the globe – is at a crossroads. As economic growth returns and inflation begins to pick up, policymakers are making tentative steps towards removing the enormous stimulus package.
However, with the 2013 Federal Reserve ‘taper tantrum’ still weighing heavily on central bankers’ collective minds, the question of when and how support will be removed – and how markets will react – is coming very much to the fore.
A long and winding road
To recap, ECB president Mario Draghi’s ‘big bazooka’ stimulus of 2015 comprised two main parts: rock-bottom interest rates and QE (buying up bonds).
In its latest announcement, the bank confirmed the three headline interest rates will remain unchanged at 0.00%, 0.25% and -0.40% respectively.
These are the rates on the main refinancing operations (which provide the bulk of liquidity to the banking system), the marginal credit facility (which provides overnight credit to banks in the Eurozone) and the deposit facility (which banks use to make overnight deposits).
All three rates have been static since March 2016 and the ECB anticipates they will stay at this level for an “extended period of time”.
The QE programme pumped €80billion a month into the European economy when it was first introduced over two years ago. This was cut back to €60billion a month in March this year before a further reduction to €30billion a month was confirmed in October 2017. The latest reduction will kick in from January 2018.
While the size of the monthly monetary injection has dropped, the length of the programme has been extended from December 2017 to September 2018 (having already moved beyond deadlines of September 2016 and then March 2017).
The ECB, unlike its US counterpart, has a single goal: to deliver stable prices in the Eurozone, with a central target of 2%.
The theory behind Draghi’s bond-buying programme is relatively simple. By purchasing vast quantities of bonds, the ECB aims to increase the price of the bonds and create money in the banking system.
This in turn causes interest rates in the market to fall and loans to become cheaper, boosting consumption and investment. This should (in theory) push inflation back towards target.
We can see from the above graph that QE has been effective in resuscitating inflation rates, halting and then reversing a trend of steady decline. However, policymakers now need to decide when and how to turn off the money taps without causing panic in the market.
The ECB is clearly treading very carefully here, and its latest statement makes clear that both the size of the stimulus and the timeline could be extended if the overall economic outlook becomes subdued and progress towards the ECB’s 2% inflation target slows.
Learning the lessons of the taper tantrum?
Draghi has been at pains to play down the significance of the latest withdrawal of monetary support. In fact, in his press conference following last month’s announcement Draghi insisted this was not tapering at all.
This just shows the monetary high-wire act ECB - and for that matter the Bank of Japan, Bank of England, Swiss National Bank and US Federal Reserve - are walking when they choose to act, or even communicate with the market. One false move and its best-laid plans could lie in tatters.
Draghi’s careful couching of the plan is almost certainly a nod to the market chaos caused by then Federal Reserve chairman Ben Bernanke’s hint in May 2013 that the US central bank was looking to taper its $85billion a month QE scheme.
Within a month of Bernanke’s initial statement global stock, bond and commodity prices had all dropped by between 6% and 12%.
The Fed finally made its first move in December and stopped adding to the programme in October 2014.
(Covers period 21 May to 24 June 2013. All returns in sterling terms.)
Source: Thomson Reuters Datastream.
Global stocks eventually regained their footing and made up all of the lost ground within a year. Equities did best among the major asset classes and Government bonds the worst – the latter makes sense as the tapering of QE removes a major buyer from the scene, or in the case of the ECB reduces its influence.
(Covers the period 21 May 2013 to 29 October 2014. All returns in sterling terms.)
Source: Thomson Reuters Datastream.
Advisers and clients will want to keep a watchful eye on markets for signs of history repeating itself as the ECB slowly tapers QE, especially as the US Fed could be about to put its programme into reverse and begin to withdraw monetary stimulus.
We’ve also seen the first quiver of activity from the Bank of England in the form of an interest rate rise – although it should be noted this simply reverses the emergency cut from 0.5% to 0.25% implemented after the EU referendum. The central bank’s asset purchase programme remains unchanged for now.
Stock market test
Any sustained tightening of policy from the globe’s central banks could also be a big test for stock markets. Since 2008, the Fed, Bank of Japan, ECB, Bank of England and Swiss National Bank have injected an astonishing $11.5 trillion between them into the financial system via QE, to the huge benefit of asset prices.
Source: Thomson Reuters Datastream, Bank of England, Bank of Japan, European Central Bank, Swiss National Bank, US Federal Reserve, FRED – St. Louis Federal Reserve database
While millions of investors have been able to ride this wave and benefit from soaring equity returns, the tapering and eventual termination of trillions of pounds of monetary stimulus is a massive global financial experiment. How central banks manage it – and the reaction of markets to their actions – will inevitably have huge implications for advisers and their clients.