What form could such a rule take which prompts a reduction in central bank bond purchases? We believe that it would make sense to attach weightings to several inflation indicators that the ECB deems to be relevant and use this as a basis for bond purchases.
As an example, we have calculated an inflation indicator comprising three equally weighted components: the rate of change in the harmonized consumer price index year-on-year in %, the annualized rate of change in a three-month average based on the seasonally adjusted consumer price index compared with the previous three-month average in %, and long-term market-based inflation expectations based on the five-year, five-year forward inflation swap rate. The indicator selected for inflation expectations plays a key role in the ECB's analyses. We have included changes in the three-month rate together with the annual rate of inflation in order to capture changes in inflation trends more quickly.
The readings of our inflation indicator have fallen steadily from around 1.8 in early 2013 to -0.3% in January of this year. Since January the figure has been ticking up again, and in March was back in positive territory at 0.1. Based on our inflation forecasts, we have extrapolated the indicator up to the end of 2016, assuming fairly stable oil prices on a slight upward trajectory, a relatively low value of the euro and an economy that continues to stabilize.
Under these assumptions, the indicator already starts to head upwards in the course of the first half of 2015, reaching around 1 by mid-year and thus no longer flagging the risk of deflation. In this event, bond purchases could be reduced by, say, 25% as early as in the summer of this year. If the inflation figure were to rise significantly above 1 towards the end of the year, a further 25% reduction in the original volume would make sense. Readings of at least 1.5, which come close to the ECB's reference value, would call for a full exit from the expansionary bond-purchasing program in order not to have to chase a runaway inflation trend. Such a rule, focused clearly on inflation developments, should not trigger any turbulence on the financial markets. The proposed tapering rule is different to that used by the US Federal Reserve. This is appropriate given that in Europe the policy is aimed not at repairing bank balance sheets, as was the case in the US, but rather clearly aims to ward off deflationary risks. Given success on this front, the bond-purchasing program, with its substantial adverse repercussions on savers and financial market stability, should be scaled back.