ECB's Policy Shifts and France's Political Crossroads

At the ECB’s annual Sintra conference last week, there was a strong call for reassessing the aggressive quantitative easing (QE) policies of the past. Some policymakers suggested that the ECB should evaluate the benefits and drawbacks of these strategies, particularly when policy rates approach the lower bound or during periods of low inflation. This debate is fuelled by concerns over the effectiveness and potential negative side effects of prolonged QE, which has created challenges in unwinding the massive asset purchases​ (The Mighty 790 KFGO | KFGO)​​ (IMF eLibrary)​.

The 2023 BIS Annual Economic Report highlighted the limitations and long-term negative consequences of extended QE. These include weakened financial intermediation due to declining bank profitability, capital misallocations, and various economic and political issues. A re-examination of QE could lead to updates in the ECB's 2021 Strategy Review, emphasizing the necessity of robust and sustained monetary policy measures when the economy is at the lower bound to prevent entrenched negative inflation deviations. This reassessment may be reflected in the forthcoming 2025 Strategy Review, impacting the 2026 discussions on the steady-state size of the ECB's balance sheet. Meanwhile, some policymakers advocate for detailed guidelines on the ECB's response to demand and supply shocks​ (The Mighty 790 KFGO | KFGO)​​ (World Finance)​.

During a panel at Sintra, the usefulness of the unobservable ‘equilibrium interest rate’ (r*) was debated. Estimating r* is notoriously challenging, with significant variance in estimates and unclear drivers. One contentious point was whether aggressive monetary easing could lower real interest rates further without significantly impacting inflation, potentially affecting income and wealth inequality. This could even question the independence of central banks if monetary policy impacts r* itself​.

Looking ahead, history may judge the large-scale QE of the past decade less favourably. Future QE could be restricted to financial stability and market-making functions during extreme stress. The Bank of England’s intervention in response to the 2023 bond market stress due to Liz Truss’s economic policies may serve as a model for temporary, targeted QE policies​ (European Central Bank)​.

In the near term, the ongoing debate on QE may influence the ECB’s response to disorderly market developments resulting from unsustainable fiscal policies. While the ECB has maintained that markets are adjusting to French political uncertainty in an orderly manner, there are calls for clearer definitions of conditions warranting ECB intervention and adherence to EU fiscal rules, especially following German Finance Minister Lindner’s doubts about the legality of using the Transmission Protection Instrument (TPI) to support France​ (European Central Bank)​.

Meanwhile, in France, coalition talks are proving to be lengthy and complex. Leaders of the left-wing New Popular Front (NFP) are currently discussing potential candidates for prime minister, a decision ultimately subject to President Emmanuel Macron's approval. If Macron opts for a technocratic prime minister, he may try to attract moderate NFP factions into a coalition. Markets seem to favour a technocratic solution, though prolonged negotiations could unsettle the bond market. 

NZD: Reserve Bank of New Zealand's Dovish Surprise

The Reserve Bank of New Zealand (RBNZ) unexpectedly adopted a dovish stance by maintaining its key interest rate at 5.50%. Contrary to expectations of a hawkish stance due to insufficient second-quarter data, the RBNZ expressed confidence in achieving disinflation. The bank's statement highlighted that restrictive monetary policy has significantly reduced consumer price inflation and projected that headline CPI would fall within the 1-3% target range by the latter half of the year. The statement also noted several signs of economic and labour market slowdowns.

Initially, forecasts included a single rate cut by the RBNZ in the fourth quarter, but today’s communication suggests the possibility of at least two cuts, with 60 basis points priced in by year-end. Policymakers likely based their stance on convincing evidence of forthcoming disinflation. Nonetheless, an upside surprise in next week’s second-quarter CPI report could counteract recent NZD losses, maintaining a positive outlook for the NZD this summer.

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