Fed, ECB to tighten policy in tandem

© Reuters. Fed, ECB to tighten policy in tandem

By Balazs Koranyi

FRANKFURT (Reuters) - Tightening policy by a notch just one day apart, the world's top two central banks will hope to signal confidence in global economic growth, despite risks of a trade war, currency swings and political turbulence.

The U.S. Federal Reserve is almost certain to raise rates again on Wednesday, inching closer to a neutral policy stance, while the European Central Bank is likely to signal on Thursday that its 2.55 trillion euro bond purchase scheme will end this year, a key move in dismantling crisis-era stimulus.

Though largely a coincidence, their twin steps suggest the era of cheap central bank cash will soon be over. That indicates major economies are strong enough to stand on their own but also that central banks are keen to replenish their policy firepower before the next downturn.

For the ECB, the next step is likely to be another in a series of incremental moves, as policymakers seek to avoid any potential backtracking, mindful of their two disastrous rate hikes in 2011, which exacerbated the euro zone's debt crisis.

The euro zone economy has been growing for over five years, employment is at a record high, wage inflation is increasingly clear and bond purchases have done all they could to cut borrowing costs, making ending the scheme the logical next step.

The ECB has already said the 2.55 trillion euro ($2.99 trillion) asset purchase program's fate will be on the agenda on Thursday but ECB President Mario Draghi must decide whether to declare the end or wait until policymakers next meet in July.

The end of quantitative easing raises a tricky issue for the ECB: interest rate hikes are tied to the end of the purchases, with the bank's guidance stipulating that rates will stay unchanged 'well past' the program's conclusion.

With no purchases into 2019, more specific guidance will be needed to keep rate hike expectations anchored and to give the bank flexibility to delay if needed.

It is expected to opt for a formula that specifies steady rates for several quarters and for as long rates are consistent with its near 2 percent inflation target.

But with growth slowing and yields on the periphery rising due to fears of political instability in Italy, downside risks appear to be increasing, suggesting to some that the ECB may try to get out early to avoid being dragged into politics.

"For what it's worth, the ECB has recently decided to look through political events," UBS said in a note to clients. "Moreover, some countries may have an interest in reducing the support to a populist government. After all, the QE program also entails buying Italian government bonds."

Some even argued that the ECB may opt for a June decision because it fears bond market turbulence later that would make a July move more difficult.

"Accelerating the end-date announcement due to fears of an even more clouded economic outlook later on, fueled by policy uncertainty, would do little to enhance the ECB's credibility" Societe Generale (PA:SOGN) economist Anatoli Annenkov said.

"The ECB would again risk committing to action too far in advance and reacting excessively to oil price movements," he added, referring to the 15 percent rise in Brent crude prices this year, which has pushed headline inflation higher.

FED

For the Fed, raising rates by 25 basis points to a range of 1.75 percent to 2 percent appears an easy call.

The U.S. central bank is meeting both of its objectives -- its preferred inflation rate is at 2 percent and the economy is at full employment.

The question is whether its rate hike projections -- three moves both this year and next -- move up and whether it expects to hit the so-called neutral interest rate quicker than earlier thought.

"The domestic risks facing the US economy are arguably tilted to the upside," ABN Amro economist Bill Diviney said.

"A significant amount of fiscal stimulus is coming on stream when the economy is by many measures close to full capacity, and growing at an above-potential pace."

An overheating labor market would argue for quicker tightening but inflation is expected to stabilize around target and the Fed is likely to be careful in any move above the neutral rate, which neither stimulates not cools the economy.

Another issue to watch will be the Fed's assessment of the growing external risk from an increasingly long list of sources, like a global trade war, or sovereign risk in places like Italy, Turkey or Argentina.