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ECB debate shifting to interest rate path from QE: sources

FRANKFURT (Reuters) - European Central Bank policymakers are shifting their debate to the expected path of interest rates as even some of its most dovish rate setters accept that lucrative bond buys should end this year, sources close to the discussion said.

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Policymakers are comfortable with market forecasts, including for a rate hike by mid-2019, and the debate is increasingly about the steepness of the rate path thereafter, as some want future expectations contained given the slow rebound in inflation, five sources with direct knowledge of the discussion told Reuters.

After more than three years of bond buying totaling nearly 2.5 trillion euros, ECB policymakers are now debating how to phase out their unconventional tools and normalize policy in a time of robust growth but weak inflation.

“The only point in extending the programe would be to push out rate hike expectations and anchor the yield curve,” one of the sources said. “But that can be done with other tools, like a more precise forward guidance or more long-term refinancing operations.”

The ECB declined to comment and the sources said that no decision has been taken on the future of the bond-buying program.

The central bank’s bond-purchasing scheme, already extended several times, is now due to expire at the end of September, and ECB staff projections assume that they would be wound down over three months thereafter.

“I haven’t seen a serious case for another extension,” a second source said. “But we need to carefully manage rate expectations, especially given the trade and fx risk.”

Worried about a potential trade war with the United States and increased volatility in foreign exchange markets, the sources said that the key decision on bond buys beyond September is likely to be taken relatively late, such as in June or July.

While the trade tariffs announced by the United States have a relatively small impact on growth, they foreshadow retaliation with potentially greater ramifications, the sources added.

ECB President Mario Draghi and chief economist Peter Praet have both argued that the amount of unexploited capacity in the euro zone economy, such as in its labor market, could be greater than earlier seen, which may slow the rebound in inflation.

The ECB is targeting an inflation rate of just below 2 percent, but it expects price growth to miss its target for at least the next three years. Greater slack in the economy would suggest an even slower rise.

Money markets are fully pricing in a 10 basis-point interest rate rise in the second quarter of next year and at least one more hike is priced in for 2019, with forward money market rates suggesting the ECB’s minus 0.40 percent deposit rate will rise to zero percent in two years.

While more conservative policymakers are comfortable with the market’s pricing, dovish members said these projections could be repriced quickly and the ECB needs to ensure that only gradual hikes are anticipated, the sources said.

“With any move we take, markets will start pricing the next one and you could see quite a sharp rise in the (expected) rate path,” a third source said. “These expectations need to be very firmly anchored by the time we take the first policy decision.”

No big decision is likely to be made at the ECB’s April meeting and only minor tweaks in the communication stance are expected for now, the sources added.

Reporting by Balazs Koranyi; Additional reporting by Dhara Ranasinghe; Editing by Hugh Lawson