Exchange Rate Implications of the ECB's Approach to Reducing Quantitative Easing

According to the ECB announcement, from January 2018 onward the quantity of assets purchased per month will be cut in half, from €60 billion to €30 billion. But the ECB stopped short of announcing a formal end date for QE, saying that purchases would continue until the end of September 2018 "or beyond," depending on the outlook for inflation, and could resume if the outlook worsened.²

The ECB also stuck to its "lower for longer" line on interest rates, saying that interest rates will not start to rise until after QE has completely ended.³ Further, the ECB will continue to purchase bonds to replace previously purchased bonds that mature: this ensures that the value of QE purchases does not fall as bonds reach their maturity date.⁴ This contrasts with the U.S. Federal Reserve, which is gradually reducing its bond holdings from its (now ended) QE programs by allowing bonds to mature without replacement. The ECB's stance reflects concern that sudden ending of QE (or too-sharp tapering), or premature interest rate increases, could cause the euro's exchange rate to appreciate, further dampening inflation that is already well below the ECB's 2 percent target.⁵

A Strong Euro Exchange Rate Complicated the ECB's QE Reduction Decision

For much of 2017, the euro's exchange rate has been rising against other major currencies, reflecting the Eurozone's unexpected economic recovery.⁶ The Eurozone's recovery has raised expectations that the ECB would soon end QE and start raising interest rates. ECB policymakers have made it clear that interest rates would not start to rise before the end of QE,⁷ but some analysts expected QE to be brought to a complete end by mid-2018, clearing the way for interest rate increases to start in the second half of the year.⁸

The problem for policymakers, however, is that the rising euro exchange rate depresses the prices in Euros of imports, including essential commodities such as oil and foodstuffs, which are priced in U.S. dollars.⁹ This is one of the factors currently keeping inflation below the ECB's target of "below, but close to, 2 percent." Despite the economic recovery, Eurozone inflation has remained at around 1.5 percent for most of 2017 and shows no signs of increasing.¹⁰ If the ECB suddenly ends QE or raises interest rates, the euro's exchange rate could rise sharply, depressing import prices even more and causing Eurozone inflation to fall.

Because of its single mandate, the ECB's primary concern is returning inflation to target, unlike other central banks such as the Fed or the Reserve Bank of Australia (RBA), for which unemployment and (in the RBA's case) economic growth are also important. For the ECB, therefore, a monetary policy decision that caused inflation to fall even further below target due to a sudden spike in the euro's exchange rate could be regarded as failing to meet its mandate.

QE is Being Reduced, Not Tapered: No Definite End Date

ECB policymakers considered several options for reducing QE:

• A "short taper," under which asset purchases would continue at €40 billion per month until June 2018;
• The "lower for longer" option, under which asset purchases would be reduced more but continue for longer;
• A 12-month gradual taper similar to that adopted by the Fed.

The ECB opted for "lower for longer" to avoid disruption to financial markets and a spike in the euro exchange rate. Policymakers also debated whether to set a clear end date for QE, but chose to keep the end date open.¹¹ The President of the ECB, Mario Draghi, commented in a press conference after the announcement that the decision shouldn't be called "tapering": it simply sets QE at the level policymakers regard as right for the Eurozone economy at this time.¹²

However, although a majority were in favor of keeping the end date open, dissenting voices included Jens Weidmann, the head of Germany's Bundesbank, who said he would have preferred a clear end date. Many German economists have opposed QE and expressed a desire for higher interest rates to support German savers.¹³