Will ECB Tapering Trigger Market Tantrum?

The European Central Bank (ECB) is widely expected to announce a winding down of its quantitative easing (QE) program on October 26. Though investors are nervous, the ECB is doing a good job preparing markets for the change.

As the ECB gears up for its October meeting, the Governing Council has yet to agree on how to taper its QE program. Indeed, the ECB has been surprisingly quiet about its policy options.

That’s changed in recent days, though. Several members of the Governing Council—particularly Chief Economist Peter Praet—have provided important insights on the most likely options.

Praet made the following observations:

  • The ECB’s asset purchases should be seen in the context of its other policy instruments. More specifically, the Governing Council’s forward guidance—which states that policy rates won’t rise until “well past the horizon of our net asset purchases”—contains important information about the likely timing of the first rate hike. The longer the program lasts, the later the first hike is likely to be.
  • The impact of central bank asset purchases depends on the state of the economy and markets at the time. In other words, when market conditions are tense, a high purchase pace over a short period is more effective. In more normal conditions (like today), a lower purchase pace over a longer horizon can be more effective.
  • The average maturity of the ECB’s bond holdings falls as its portfolio ages, putting upward pressure on bond yields. Replacing maturing securities with longer-dated bonds can help ease the pressure, but by itself isn’t sufficient to prevent a gradual—and, at this point, inappropriate—tightening of financial conditions.