From Westpac’s Elliot Clarke and James Shugg:
Amidst growing evidence that the risks of an entrenched (and broadening) deflation trend are crystallising, the past eight months have seen ECB policy take a more proactive approach.
Over two steps in June and September, the Council reduced lending rates to the lower bound; implemented a negative interest rate for deposits held at the central bank; and offered immediate liquidity via two targeted long-term refinancing operations (TLTROs) in September and December 2014, which collectively saw €212bn of
liquidity provided to the system. That was well below the €400bn ceiling, and not even enough to offset the ongoing repayment of the LTROs from three years ago; so the ECB’s balance sheet tended to shrink despite these measures, even as ECB Chief Draghi was reiterating an intention to expand the ECB’s balance sheet back
towards its size of 3 years ago, around €3trn compared to just over €2trn in the second half of last year.With that in mind, and with the unstated intention of demonstrating that a sovereign bond purchase program is the only feasible way the ECB could achieve the scale of balance sheet expansion required, purchase programs for asset backed securities (ABSAPP) and covered bonds (CBAPP) were announced in October 2014. To date
they have added a modest €11bn per month to the ECB’s balance sheet – at that pace, it would take seven years to achieve the intended balance sheet expansion.President Draghi then set the agenda for the January Council meeting in December, noting: “[we] will reassess the monetary stimulus achieved, the expansion of the balance sheet and the outlook for price developments… should it become necessary to further address risks of too prolonged a period of low inflation… [we] would alter … the size, pace and composition of our measures.”
He also added that work on the necessary technical measures had been stepped up, and emphasised that the one trillion euro expansion of the ECB’s balance sheet was now “intended” and not just “expected”. Here then are two potential triggers for the ECB to embark on further easing: should measures already announced not
be sufficiently calibrated to deal with the unfolding inflation outlook; or should policy be unintentionally tightened by (for example) a fall in inflation expectations.Since December, Eurozone inflation has fallen below zero and inflation expectations on the ECB’s preferred measure have fallen from over 2% in June, when the ECB announced the current TLTRO balance sheet measures, to below 1.5% earlier this month. Also of import, perceived legal obstacles to ECB bond buying have been
undermined by the European Court of Justice opinion in favour of the OMT bond-buying program and Draghi’s own claim that it is the intention that determines legality: i.e. unsterilized ECB bond buying for monetary policy purposes does not breach the EU Treaty rule that the ECB cannot finance governments by printing money.If we have learned anything from the past three years, it would be that Draghi’s words carry great weight, although the Bundesbank continues to argue with futility against the legality and need for bond purchases.
Markets are therefore priced for a substantial policy announcement on Thursday; there is some risk that Draghi does not deliver enough on the day to justify recent pricing in currency markets, peripheral bond and credit market spreads and equities.
At the very least, we expect Draghi to pre-announce a broad-based QE program, even if its key modalities are held over for specification at the March 5 policy window.
In addition to details covering the monthly purchase volume, intended length, total program size and split between sovereign bonds and other assets, there are other complications unique to the Eurozone that will need to be resolved. These mostly relate to central bank seniority over other bond holders in the event of a sovereign default; the mutualisation of credit risk implied by largescale ECB purchases of debt issued by nearly 20 member states; the roles of the national central banks (and the degree of risk they take on unilaterally); and the weightings to be used to determine the relative proportions of member states’ bonds to be purchased. Westpac has argued since 2010 that the monetary policy endgame for the Eurozone crisis would be a quantitative easing program. It won’t solve the crisis, but it should buy more time for European governments, institutions, firms and individuals to make the structural changes and reforms necessary to operate competitively within the constraints of a single currency into the longer term.
QE should achieve this via various channels, including crowding out investors and forcing them to move further out in terms of bothmaturities, credit risk and even currencies held in the search for yield. For example, German bunds out to a tenure of 5 years already have negative yields in anticipation of ECB QE, making peripheral bonds, corporate bonds or even non-euro assets more attractive to European investors – the latter helping to lift both inflation andcompetitiveness at the margin.
The question that needs to follow the mechanics and likely immediate market impact of alternative easing is what it all meansfor the health of the Euro Zone economy.
As alluded above, there are material impediments to QE’s success in the Euro Area, most notably the region’s substantial structural concerns and uncertainty over the real-economy impact of alternative measures. This is where we will turn following the January meeting.
