Exceptional economic growth and a sustained rebound in inflation provides room for the European Central Bank to dial back stimulus, Dutch policymaker Klaas Knot said, warning the Bank was at risk of normalising policy too slowly. Considered a hawk on the ECB's Governing Council, Knot said in an interview with Reuters that he was comfortable with market expectations for an end to bond buys in the fourth quarter and a first interest rate hike since mid-2011 in the second quarter of next year.
He added that he was not overly concerned by recent euro gains and argued that policy tightening should be slow and gradual given high levels of debt. Having kick-started growth by pushing borrowing costs to rock-bottom levels, ECB policymakers are now considering how and when to end their 2.55 trillion euro ($3.16 trillion) bond purchase scheme, taking another step in winding down crisis-era stimulus and reverting to conventional policy tools.
Markets expect the ECB to exit the quantitative easing (QE) programme in the fourth quarter, then raise rates in around April or May. "If you look at the market expectations of our policy action, I would say they have more or less converged at what I call a sweet spot," Knot said. "There is a fair degree of consensus around these expectations."
"I would say the likelihood of us erring on the side of being too cautious is a bit larger than for us being too bold," Knot said as the Dutch central bank - which he heads - presented its annual report. Knot has been one of the ECB's most prominent opponents of the stimulus measures.
But his comments suggest that, with the Bank having averted the threat of deflation and presided over 20 straight quarters of economic growth, the policy debate is shifting away from bond purchases toward the interest rate path. The Bank has said it would end bond buys once inflation is on a sustained upward path towards its target of almost 2 percent, which Knot said was not far off.
"I think we are getting relatively close," Knot said, arguing the remaining deviations from such an adjustment are limited, particularly with view to the medium term, the ECB's policy horizon. Annual euro zone inflation data due on Wednesday is expected to show a rise to 1.4 percent in March.
Moving too slowly on unwinding stimulus could force the ECB to tighten policy quicker later on, potentially boosting market volatility and braking growth by sharply raising the economy's debt burden. Once bond buys end, interest rates should again become the ECB's main policy instrument and the reinvestment of maturing debt could act as stabilising tool, said Knot, sometimes mentioned as a potential candidate for a seat on the ECB's six-member board.
The ECB has long flagged a discussion about revising its policy guidance - which currently ties changes in rates to the end of asset purchases - and Knot said it was appropriate to begin this process now. But new guidance may need to wait until the ECB decides the future of bond buys beyond September, the programme's tentative end date.
"To the extent we want to continue giving guidance to the market, the guidance should primarily focus on interest rates," Knot said. "We don't need to cement credibility on the rates by continuing to purchase assets," Knot said, arguing that the stock of purchased assets was so large that the net flows "don't matter that much anymore".
"Let there be no doubt about it that the process (of normalisation) will be gradual and slow," Knot said. "Rates will continue to be accommodative for quite a significant period." Reflecting on currency market volatility, one of the ECB's main concerns in recent months, Knot argued that the euro's rise was primarily a natural development reflecting the bloc's strong economy.
"We will continue to monitor but the recent exchange rate appreciation is not a big cause of concern for me," he said. A recent soft patch in euro zone indicators was also not a major worry as some volatility in economic readings was also natural.
"I don't think we can grow much faster than this and inevitably you'll see a gradual return to levels closer to potential," Knot said. "But ...economic expansions don't die of old age."