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The European Central Bank’s Long-Term Challenges

May 22, 2018

 

Looking back into time, the European Central Bank’s (ECB) monetary policy decisions have been straightforward, but the time following 2020 could lead to some problems as the bank will face a more complex set of challenges in decision-making. The unemployment rate could fall, and economic growth could persist if the ECB tapers its asset purchase program to zero by the end of 2018 followed by a small increase in the deposit facility rate after the tapering. This will set the ECB up in a good position to raise interest rates by the end of 2019. As the current ECB president’s term comes to an end in October 2019, investors should stay tuned for the events leading up to policy changes and Mario Draghi ending his term.

 

However, leaving his position in a time like 2019 could mean that his successor will face a different set of challenges. One will be analyzing the extent to which the ECB can normalize policy rates before the U.S. and also before the eurozone economics fall into a recession. Another challenge Draghi’s successor will face is calibrating the instruments through which the ECB implements its monetary policy. This is not the end to the problems and challenges as there could be tensions of the U.S. Federal Open Market Committee (FOMC) raising the fed funds rate to 3.4% by the end of 2020.

 

Analysts following macroeconomic trends claim, “We tend to think the market overestimates the extent to which the ECB can normalize policy rates. Gross exports of goods and services made up 47% of eurozone national income in 2017. Europe’s dependence on external demand will limit the extent to which the ECB can raise rates beyond zero once global growth slows down.”

 

The ECB will have to use its balance sheet to counter deflationary pressure when confronted with the next recession since it will have limited scope to cut policy rates. With policy rates nearing zero during the next downturn, one way for the ECB to lower its term structure of interest rates would be to receive interest rate swaps while buying private sector assets. Lowering its term structure will also reduce firms’ borrowing costs, but as long as the eurozone lacks a centralized fiscal capacity, banks and their sovereigns will stay interlinked.

 

With all of this in mind, Europe’s unconventional policies and low levels of interest rates are likely to persist. Investors in the eurozone short-term markets should expect a new phase of unconventional monetary policies in the near future.

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