ECB on an even keel — Le Pen permitting

The ECB has been one of the two main providers of global monetary easing since 2015, and that seems likely to persist throughout 2017. Despite its continuing importance to the setting of global monetary conditions, its policy deliberations have made only little waves in the markets since deflation risks abated last year.

The Eurozone economy seems to be in an increasingly healthy state, at least from a cyclical point of view, and monetary conditions appear to be normalising across the entire region. The latest rounds of asset purchases have proven more successful than previous doses, primarily because they have reduced sovereign and other credit spreads in the troubled economies, thus bringing monetary assistance to countries that needed it most.

Although Bundesbank President Weidmann has become a little restless about the longevity of the Asset Purchase Program, at a time when the economy no longer seems in need of emergency assistance, the hawks on the Governing Council (GC) have not been ready to press the case for tightening. President Draghi still seems to be in total control of a Council largely dominated by doves.

While the Eurozone economy and the ECB’s state of mind seem to be an a fairly even keel, there are two ways that this could change in 2017. On the good side, the surprising strength of activity growth could bring an abrupt end to balance sheet extension in December, or tone down the dovish nature of the ECB’s forward guidance earlier than that. On the bad side, the (highly improbable) election of a President Le Pen in France could throw the single currency area into immediate chaos that the ECB would be powerless to control.

The ECB’s monetary stance

First, let us examine the “business as usual” case, assuming Le Pen loses. When will the ECB consider a shift away from the current programme of aggressive monetary accommodation? The main case for a hawkish change stems from the robust nature of recent economic growth across the entire region, not just in Germany:

The Fulcrum nowcast suggests that the latest growth rate is 2.8 per cent, with all four of the largest member states recording growth above 2.1 per cent. This is very different from earlier bursts of strong growth in continental Europe, which were dependent on the strength of Germany as the solitary locomotive.

Furthermore, although the nowcasts have been somewhat affected by the buoyancy of survey data, Germany has not be subject to the same gap between hard and soft data that has been apparent in the US. Unless growth rates fall soon, consensus and ECB forecasts for GDP growth in the Eurozone in 2017 will need to be marked upwards.

Why has the ECB’s thinking on monetary policy remained so dovish? Inexplicably, the GC still considers that risks to growth are “on the downside due to global factors”. Given the incoming data, this will surely need to change soon. More importantly, the recent rise in headline inflation has not been accompanied by any sign of a rebound in core inflation. The latest core inflation report (adjusted by us for the timing of Easter) suggests that the underlying trend remains fixed at 0.9-1.0 per cent:

The GC is committed to the current policy stance until inflation has returned to target on a sustainable basis. The minutes for the March meeting show that the Council is still very concerned about the low levels of wage settlements that are now in the system for 2017, implying that core inflation will stay very low well into next year.

Last week, President Draghi said very forcibly that the current dovish package – maintaining the APP at €60bn a month until December, and keeping key ECB interest rates at present or lower levels until well after the end of the APP – should be seen as a single package, in which the sequencing of measures is fixed. He forcibly ruled out raising rates before the APP ends, a strategy that has been discussed by at least one GC member recently. This means that there will be no significant shift towards early policy tightening, though the easing bias reflected in the skew towards “lower rates” may be removed from the forward guidance fairly soon.

Handling a Le Pen shock

Although the ECB is navigating calm waters at present, the French Presidential election certainly has the capacity to cause upheavals. Should Marine Le Pen perform better than expected in the first round on 23 April, there could be market turmoil in the fortnight before the second round.

The ECB has the weapons to address this. The central bank would allow French banks to access temporary liquidity, and would skew its asset purchases towards French bonds. But these operations would have the effect of increasing Target 2 imbalances within the ECB balance sheet as private capital flowed from France to Germany.

Germany would probably allow these Target 2 claims on the Eurosystem to rise during such a period of temporary stress. Worryingly though, these claims already stand at €750bn, having risen during the systemic euro shock in 2011-12, and then more recently as a result of the ECB’s Asset Purchase Programme in 2015-17 (see Izabella Kaminska at FT Alphaville).

Such claims are irrelevant in circumstances where the euro remains intact, since they would simply represent entries on the central bank balance sheet, and would probably be reversed over time. But if the future of the euro and the ECB itself were thrown into doubt by a major political upheaval, the legal nature of these claims would probably be questioned in Germany, leading to intense political pressure that they should be capped.

The election of a President Le Pen on 7 May would qualify as a titanic political shock. Admittedly, she may have already watered down her anti-EU rhetoric in efforts to attract the centre ground during second round campaigning. And it would be unclear whether she would be able to win a majority in the National Assembly elections in June, without which a referendum on euro membership becomes impossible.

But the markets are unlikely to be patient while these political events unfold. It is highly likely that there would be an immediate run on the French banking system if Le Pen, or hard left candidate Jean-Luc Melenchon, enters the Elysee.

The ECB would then face an agonizing dilemma. A promise by President Draghi to do “whatever it takes” to keep the euro intact would not be credible if France is threatening to withdraw and Germany is refusing to allow Target 2 imbalances to rise further. The market disruption would quickly become systemic, with Italy rapidly moving to the epicentre of the crisis.

The only option at that point would be to follow the Greek example in the summer of 2015, imposing capital controls in many Eurozone countries and freezing convertibility of internal banking accounts until a new political settlement is reached. As in Greece, the economic turmoil in France may eventually be sufficient to change the political mood and thus end the possibility of Frexit. But this could only happen because of a political change of heart, not because the ECB decrees it to be the case.

This market nightmare remains highly improbable. The opinion polls were wrong in the UK and the US last year, but the margins for error going into the election were small. In the French Presidential election, the polls would need to be spectacularly wrong, not just slightly biased, for Le Pen to win.

This post originally appeared on Financial Times

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