May 2, 2018 / 1:07 PM / 21 days ago

Weak growth may test ECB resolve to roll back stimulus

FRANKFURT (Reuters) - The European Central Bank will not easily retreat from plans to end its bond purchases this year, even though growth is slowing, but it may push out expectations for interest rate increases to maintain the flow of money and support confidence.

The logo of the European Central Bank (ECB) is pictured outside its headquarters in Frankfurt, Germany, April 26, 2018. REUTERS/Kai Pfaffenbach

The euro zone’s economy has expanded for 20 straight quarters, but a string of indicators suggests that growth has slowed in early 2018, with the threat of a global trade war further clouding the outlook.

The slowdown comes at a sensitive time for the ECB. Its policymakers are debating whether to end bond buying this year, assuming rapid growth will eventually raise inflation, even if price growth will undershoot its target for years to come.

Cutting stimulus during a slowdown could weaken investor confidence and raise doubts about the ECB’s resolve to lift inflation to its target of just below 2 percent.

Yet small additions to the ECB’s 2.55 trillion-euro bond- buying scheme are likely to do little for borrowing costs. And a major extension would require expanding the list of eligible assets, a politically difficult move.

That makes it harder for the ECB to reconsider ending quantitative easing (QE) this year. A substantial deterioration in growth or inflation would be needed.

“You would need to see a pretty dramatic slowdown in the rate of demand growth below the level that the ECB thinks is consistent with potential supply growth – so below say 1.5 percent,” Kallum Pickering, an economist at Berenberg, said.

The ECB could still dampen rate hike expectations, if growth continued to falter.

For now, though, policymakers speaking privately say they are not eager to rein in market expectations. They argue that the slowdown is at least partly temporary and rising oil prices will ease any downward pressure on inflation.

Economic growth slowed to a quarterly 0.4 percent in the first three months from 0.7 percent in each of the preceding three quarters. That was a big but not unexpected drop, since the bloc is running out of spare capacity and has expanded at twice the rate of its potential.

Strikes, cold weather, doubts about free trade and an especially vicious winter and flu season contributed to the drop, fuelling hopes that the bloc will bounce back.

Indeed, soft indicators like sentiment and manufacturing surveys already suggest that growth has at least leveled off early in the second quarter, even if hard indicators have yet to confirm this.

The ECB forecasts growth of around 0.5 percent for each of the last three quarters of the year, suggesting that even if the first three months was big miss, growth around this level was penciled in for the rest of the year.

OPTIONS

The weak readings and uncertainty about the rebound suggest the ECB will not decide until the last possible moment about future bond buys, which are due to expire at the end of September. That means a final decision may not come until July.

“To extend the asset purchase program, you have to change some of the parameters, which comes with political and economic risks,” said Dirk Schumacher, an economist at Natixis. “... You really have to have good reasons to change the plan.”

Key policymakers argue that additional purchases would do little to cut the premium needed to buy longer-dated bonds, so the economic case for more asset buys is also lacking.

The most likely option to counter unexpected growth and inflation weakness would be to guarantee low rates for even longer. Markets now see a rate increase in June 2019, a delay from April, the expectation just a few weeks ago.

“For the ECB, it will be an immense success if they can finish QE. It’s way too soon to talk about raising rates considering the slowdown we’re seeing in Europe,” said Kenneth Broux, an analyst at Societe Generale.

Specific guidance could guarantee low rates. Another round of long-term loans for banks could also effectively lock in low rates for years to come. But a shallower rate path would also reignite a debate among policymakers about the inflation target.

Doves maintain that accepting anything less than 1.9 percent would threaten the credibility of the ECB. Hawks argue that as long as growth is above potential, inflationary pressures will continue to build and the ECB can afford to be patient.

(1 = 0.8336 euros)

Reporting by Balazs Koranyi, editing by Larry King

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