Central Banks

ECB to hold steady this week as traders eye a September ‘taper’ of its bond-buying program

Key Points
  • The European Central Bank is widely expected to hold interest rates steady on Thursday
  • ECB President Mario Draghi's speech in Sintra, Portugal, was interpreted by many as a sign that the central bank could start "tapering"earlier than expected
  • The rationale for the ECB to start the "tapering" despite subdued inflation was announced in Sintra

The European Central Bank (ECB) is widely expected to hold interest rates steady on Thursday with many market watchers expecting the bank to announce in September plans to reduce its bond-buying program.

ECB President Mario Draghi's speech in Sintra was interpreted by many economists as a sign that the central bank was more optimistic about the economy and could start "tapering" earlier than expected. Since his speech in June, the ECB has tried to calm down those expectations in order to prevent an unwanted tightening of monetary conditions.

Mario Draghi, President of the European Central Bank (ECB), speaks during a news conference to discuss monetary policy in Tallinn, Estonia, on Thursday, June 8, 2017.
Peti Kollanyi | Bloomberg | Getty Images

"Our mission is not yet accomplished. We need patience and persistence. We need to be patient, because inflation convergence needs more time to show through convincingly in the data," the ECB's Chief Economist Peter Praet said in a speech July 6 in Paris. In the same speech, he also said that the recovery in the euro zone "seems to have gathered further momentum."

That's exactly the difficult situation the ECB is in: While economic growth is surprisingly strong with both hard data and also sentiment indicators pointing to a solid recovery, inflation is nowhere close to target of below but close to 2 percent. Headline inflation for June even declined slightly to 1.3 percent from 1.4 percent in May with core inflation though slightly increasing by 0.2 percentage points to 1.1 percent.

"The ECB will continue to face little home-made inflationary pressure," writes Carsten Brzeski, chief economist for Germany and Austria at ING-DiBa, in a note.

"If anything, the drop in oil prices, the pick-up in bond yields and the strengthening of the euro have further deteriorated the ECB's inflationary outlook."

New staff projections for inflation and growth will be published in September, that's when the majority of economist polled by Reuters also expect Draghi to announce a reduction of the asset purchase program starting from January next year.

The rationale for the ECB to start the "tapering" despite subdued inflation was announced in Sintra.

"As the economy continues to recover, a constant policy stance will become more accomodative and the central bank can accompany the recovery by adjusting the parameters of its policy instruments - not in order to tighten its policy stance but to keep it broadly unchanged," Draghi said on June 27 in Sintra.

Other policy makers backed this assessment.

Draghi wants to be doing more QE, not less: BNP Paribas

"Speeches by Praet and (Governing Council member François) Villeroy (de Galhau) have since made similar points, while the June accounts spoke of an "accelerator effect" suggesting that there may be room to "adapt the intensity" of policy action", says Anatoli Annenkov, senior European economist at Societe Generale, in a note.

The ECB clearly wants to prepare the markets for an exit of their ultra-loose monetary policy stance without creating further distortions in the markets.That's like a dance on a volcano given the nervousness of investors in currency and bond markets.

September is the new "D-Day" which may give markets a clear roadmap of what will happen to the asset purchase program in 2018. The majority of economist expect a six-month extension with a reduced volume.

In Tallinn, at the ECB's last monetary policy meeting, Draghi said: "the ECB will be in the markets for a long time."