The ECB's Coming New Stance on QE
For months I have argued that the European Central Bank (ECB) is not likely to move quickly toward new monetary stimulus, including the purchase of sovereign bonds. I have now shifted my expectations. I believe that at its next meeting, the ECB will likely commence a broad based asset purchase program, including euro area sovereign bonds. These thoughts are offered in the spirit of John Maynard Keynes's famous answer to a critic asking why he changed his mind about monetary policy. "When my information changes, I alter my conclusions," the great economist said. "What do you do, sir?"
Two Main Reasons for the Shift
The Saudis Did It
Unexpectedly large oil price declines have dropped inflation to negative 0.2 percent, according the to the Eurostat flash estimate for December. The ECB's December 2014 economic forecast for the euro area revised the central bank's inflation forecast down to 0.5 percent in 2014, 0.7 percent in 2015, and 1.3 percent in 2016. Since that revision, however, oil prices have fallen from $75 per barrel1 to less than $50 per barrel, making a further revision likely in March. Ironically, the timing of what amounts to a positive shock—with its trade deficit in oil of more than 2 percent of GDP—will have delivered an otherwise politically impossible degree of monetary stimulus in the euro area.
The Saudi Arabian shift on oil prices highlights the risks to any central bank of tolerating a prolonged period of low inflation—or "lowflation." Even if the ECB were right, and the euro area avoided a negative shock to tip it into negative headline inflation, an inopportune positive shock would have had the same effect.
Negative inflation means that even under the most hawkish interpretation of the ECB's price stability mandate of "below but close to 2 percent," the ECB is falling short, giving its president, Mario Draghi, greater ability to persuade hardliners of the need for action.
Normally central banks focus on the developments in core inflation, which excludes food and energy. But the ECB, for reasons of its own independence,2 has focused on headline inflation data. It cannot shift that approach now without looking inconsistent. Besides, the sheer scale of the oil price decline makes it even harder for the ECB to ignore the energy effects, however temporary they are, because of the risk of fueling deflation if firms in a weak economy lower their prices because of lower energy costs. In general, falling prices of specific goods or services do not deter economic activity. The prospect of lower prices of computers does not, for example, keep consumers from purchasing them now. A greater risk to economic growth is that euro area employers, suspecting that deflation will boost real wages, may insist on minimum or even zero nominal wage increases in upcoming negotiations, reducing their purchasing power and dampening growth prospects.
The Banks Aren't Coming to the Rescue
The ECB launched initiatives to expand its balance sheet in June, including the purchase of asset-backed securities (ABS), covered bonds and new 4-year Targeted Long-Term Liquidity Operations (TLTROs). I have argued that these measures were sufficient to reach the €1 trillion goal set by Draghi. But recent data suggests otherwise because of higher levels of purchases required to counter the effects of energy price declines.
Only 306 euro area banks accepted less than €130 billion in new 4-year liquidity in the TLTRO facility in December, for example, bringing the total taken out by euro banks to little more than half the €400 billion made available, and less than €381 billion in outstanding longer-term ECB liquidity provisions last September. Thus the ECB longer-term liquidity provision will be a shrinking component of the ECB balance sheet in early 2015, when previous 3-year operations expire. The ECB seems to have reached a saturation point of how much new liquidity it can inject.
At the same time, ECB purchases of covered bonds (€29.6 billion) and ABS (€1.7 billion) have expanded the Eurosystem securities portfolio by less than €22 billion since September, setting an unsatisfactory pace for dealing with the latest negative inflation numbers.
The wait-and-see position of ECB hawks has become untenable, forcing the ECB to shift course.
What Will the ECB Do Next?
Announce on January 22 and Initially Exclude Greek Bonds
The most likely action will occur on January 22. Waiting another six weeks has become too risky. A widespread expectation is for purchases of sovereign bonds, though actual buying may not start right away. The Swiss Central Bank lifting its floor against the euro on January 15 underscores the likelihood of such a step.
A late January launch date makes it less likely that Greek government bonds would be included, to avoid an appearance of trying to influence Greek elections due January 25—the opposition Syriza party has called on the ECB to purchase Greek government bonds—and to boost hawkish support on the governing council and eliminate any moral hazard implications of rewarding Greece.
The recent preliminary ruling by the European Court of Justice (ECJ) on the legality of the Outright Monetary Transactions (OMT) program, which is explicit about barring the ECB from fiscal support for member states, strengthens this point of view.
The ECB is also likely to try for maximum impact and go beyond sovereign bond purchases to include all remaining eligible asset classes in a single new announcement. The effect of the ECB's new role as a banking supervisor could pose a conflict of interest problem because of its purchase of securitized bank loans from banks it regulates and monitors in terms of the performance of their assets. Accordingly, banking sector assets are not likely to be a major component of the new program. Bonds of some supra-national regional entities like the European Investment Bank (EIB) may be included in limited amounts, however.
Sovereign Bond Purchases Will Be Larger than Previously Indicated But Not Open-Ended
Will the ECB announce that new asset purchases are to continue until inflation is close to but below 2 percent?3 Or will it set a more specific goal for purchases? The latter strategy of setting a fixed amount seems more realistic. An open-ended purchasing program would undercut Draghi's oft-stated insistence that growth and inflation levels must be restored through fiscal consolidation and structural reforms as well as an accommodating monetary policy. Embarking on open-ended asset purchases would expose the ECB to the failure of euro area leaders to undertake such policy efforts, an untenable situation for most governing council members, effectively ending the ECB's closely guarded independence.
The recent preliminary ECJ ruling on the OMT program further subjects the OMT to a generalized "proportionality test," asserting that an assessment must be made "in light of the scale it [the OMT program] might have." The ECJ advocate general attachs importance to the ECB's argument that, despite its publicly announced "potentially unlimited scope," the central bank limits the amounts of its OMT related interventions. The ECJ position on the OMT thus generally agrees that ECB sovereign bond purchases cannot be open-ended.
Euro area headline inflation is half a percentage point lower than last September, when Draghi set the ECB's balance sheet expansion target back to levels of early 2012. Hence to get close to 2 percent in the short-term amid shrinking balance sheet contributions from long-term liquidity provision makes it likely that the ECB will expand its new purchases beyond the €1 trillion implied in September. Beyond these reasons, only sovereign bond markets are sufficiently liquid to enable large-scale purchases by the ECB in a timely manner.
ECB Sovereign Bond Purchases Will Be According to the Capital Key and Overwhelmingly Held By National Central Banks
The design and geographic distribution of sovereign bond purchases will be politically contentious. To make the purchases look objective and politically neutral, they will probably be distributed according to the shareholding capital key of the ECB. Private assets might substitute for sovereign bonds in small debt markets like Estonia or Malta. Discriminating in favor of AAA-rated sovereign bonds will be too controversial, implying concern about country risk. In Washington, such a policy would be seen as a stealth strategy to weaken the euro to improve exports.
A major question will be whether to purchase bonds on a fully risk shared basis, placing them on to the mutualized ECB balance sheet, or to enlist each national central bank to buy its own sovereign bonds and place them only onto its own balance sheet. The problem arises because the euro area is not fully institutionalized and integrated with an area-wide liquid government debt instrument like eurobonds. The existence of a variety of different credit ratings below the top-AAA rating implies an inherent cross-border risk transfer if the ECB itself buys the bonds.
Unlike normal financial assets, sovereign bonds in advanced economies are generally regarded as risk-free, reflecting the full faith and credit of a government, even though obviously they reflect the issuing entity's political credibility. The euro area was—perhaps recklessly—designed as a stand-alone monetary union without a fiscal union, because of its members' aversion to further European integration at that time.
The absence of eurobonds in the forthcoming quantitative easing (QE) reflects euro area members' political inclinations. The United States, Japan, and the United Kingdom would obviously conduct monetary policy and QE using national sovereign bonds. Not so in the euro area, where the closest strategy to that one would be for each national central bank to purchase the bonds of its own sovereign. Purchasing sovereign bonds and placing them onto the mutualized ECB balance sheet would arguably involve the ECB taking a step toward integration beyond what was implemented by the framers of the Maastricht Treaty.
To be sure, the ECB has taken such steps since 2009, including the Securities Markets Program (SMP) and the OMT. But these decisions were driven by the desire to keep the euro area together. Today, however, a breakup of the area is not imminent, and nationally distributed purchases are available as an alternative. Given the legal constraints imposed by the ECJ and the political risks, most sovereign bond purchases are likely to be conducted on a national basis,4 while only a small part might be done on a mutualized basis.
Such caution will disappoint many commentators and advocates of eurobonds. They want the euro area to look more like the United States. But eurobonds, while desirable in the long run, are not necessary now. The ECB should avoid mutualized sovereign bond purchases because they would involve unnecessary political risk for little gain. They would be just as politically objectionable as eurobonds to many in Europe, and they would not be any more effective in combating deflation than distributed bond purchases.
Why Markets Should Welcome Nationally Distributed Bond Purchases
To see the ECB as facing a choice between the default risk residing on its mutual balance sheet or solely on the national balance sheet is misguided, ignoring the complexity of the euro area's institutional framework. It is easy to assert, in such flawed analysis, that a hypothetical default of a euro area sovereign bond held only on the balance sheet of the national central bank would amount to a policy failure. In fact, both potential outcomes would represent different policy failures, as either:
- the ECB would be exempted from haircuts, as any financial losses would be transferred back to the (already defaulting) national government. This would obviously undermine the pari passu (requiring all creditors to be treated equally), under which the ECB will conduct QE and potentially undermine the effectiveness of the entire measure, because market participants would likely dump such bonds; or
- the financial loss would be transferred from the national central bank to the ECB as a whole and hence mutualized across the euro area. This would mean the failure of the attempt to isolate the risk with the national government and potentially result in the ECB breaking the EU Treaty's prohibition against monetary financing and incurring shared financial liabilities.
A hypothetical future crisis in a euro area member state would produce a different sequence of events.
Politically, any purchases of sovereign bonds by the ECB or European System of Central Banks (ESCB) would have to be of risk free assets, subject to the euro area guarantee against any future restructuring. Such a guarantee would be backed by the euro area crisis institutions of the European Stability Mechanism (ESM) and OMT, invoking the mutualized nature of any such financial support. Unlike any ECB QE purchases, the guarantee becomes subject to the political conditionality of the ESM. With the exception of Greek government bonds, it makes no sense to assign all credit/default risk to national central banks in relation to distributed central bank purchases of sovereign bonds. Such a step would ignore the entire institutional apparatus created by the euro area since 2009.
Thus even national central bank purchases of sovereign bonds will be backed by a politically conditional mutual euro area guarantee. Financial solidarity in the euro area is and would remain large, based on a quid pro quo among still quasi-sovereign nations. In the end, therefore, while there are important differences between mutualized and nationally distributed euro area sovereign bond purchases, this is not the case from a credit default risk point of view5.
A euro area member getting into a future crisis, moreover, would not be on its own with a choice of breaking pari passu or transferring the risk to the rest of the euro area. Rather it would seek financial assistance with the ESM and potentially even an OMT program, under which purchases would be politically conditional, fully legal and all mutualized.
Accordingly, irrespective of which type of sovereign bond purchases are implemented by the ECB, the opportunity exists for fully mutualized bond purchases. Just as it does not matter to the immediate survival of a bank whether it gets liquidity from the ECB or Emergency Liquidity Assistance from its own central bank, it does not matter whether QE bonds are placed on the ECB or Eurosystem consolidated balance sheet.
The ECB will look for a big market signaling announcement. It will not get that impact from mutualizing purchases. Rather the maximum impact will come from potentially unanimous support on the governing council for nationally distributed purchases on a large scale. The ECB hawks will be more comfortable with nationally distributed purchases, as these will not entail risk of politically unconditional shared financial liabilities arising in the euro area from ECB monetary policy decisions. In light of the recent preliminary ECJ ruling, the program design is also likely to withstand future legal challenges.
Market participants looking for the largest possible sovereign bond purchases by the Eurosystem should therefore welcome a nationally distributed program as the only way that the ECB can undertake more purchases later if these steps prove ineffective. Distributed purchases thus offer the only prospect for a hypothetical QE2 in the euro area.
The argument that anything short of full risk sharing of purchases would be seen as falling short of the ECB's pledge to do "whatever it takes" is not valid. Nationally distributed bond purchases will not undermine the concept of a single currency union by renationalizing monetary policy.
What Will Sovereign Bond Purchases Do for the Economy and the ECB?
Additional asset purchases are unlikely to stimulate euro area short-term growth because of the difficulty of overcoming poor bank demand for new cheap ECB liquidity and already record low sovereign bond yields. Investors have placed increasing amounts in negative yielding euro area sovereign debt (€1.2 trillion recently, up from €500 billion in October 2014 and zero in June 2014), which suggests a modest portfolio rebalancing channel (the shift away from asset classes purchased by the central bank and into higher yielding riskier assets). Moreover, unlike the Federal Reserve and Bank of England in 2008–09, the ECB is not facing a crisis and cannot reap any crisis stabilization benefits from its actions.
But sovereign bond purchases ought to help bring longer-term inflation expectations back to about 2 percent, an important monetary achievement even if there is no growth boost. Politicians looking for the ECB to bail them out from painful decisions may of course not be satisfied.
Do not, however, expect sovereign bond purchases to signal a new more activist monetary policy by the ECB. Until oil prices collapsed, after all, the ECB was complacent about low inflation. A more intriguing question relates to what Eurosystem sovereign bond purchases might lead to long term. Whether sovereign bonds are purchased by the ECB or national central banks, they will end up on the official sector balance sheet. Euro area politicians can do what they want with them. In a currency area, where the institutional set-up has changed dramatically in recent years, this opens up longer term perspectives for potentially achieving additional euro area integration.
The longer that government debt roughly proportional to the capital key of the ECB sits on the ESCB balance sheet, the more this debt will begin functioning partially like a eurobond.
As an advocate of more euro area integration, Draghi should use the eventual pullback from QE to launch a discussion of this issue, preferably quickly. The ECB should not waste the opportunity by allowing only monetary policy and financial stability considerations to dictate how it offloads what it has purchased.
Once euro area political leaders are included in the discussion, the range of exit options grows wider. Only democratically elected politicians can deliver the genuine euro area debt mutualization and cross-border financial liabilities that the EU Treaty explicitly forbids for the ECB.
Treaty changes and other reforms of euro area governance will be required as well. Euro area leaders could convert the debt owned by the ESCB into perpetual debt at zero interest. The ESCB's debt could also be converted into a new instrument like a eurobond before it is resold to private investors. Doing nothing and selling bonds back to private investors or letting them mature would be a waste.
In the end, the eventual QE exit may matter more than its launch.
2. The ECB is unaccountable to elected bodies. Draghi's frequent appearances before the European Parliament are information sharing and have no actual oversight functions. The ECB derives its mandate and institutional independence from the EU Treaty and politically from the euro area populations. Consequently, the central bank needs to cater to the prices actually seen by consumers in the euro area, e.g. headline inflation.
3. The ECB cannot therefore like the Federal Reserve choose to rely on a series of indicators to decide when to end sovereign bond purchases.
5. Judging from the earlier experiences of the ECB's Emergency Liquidity Assistance program (ELA), where national central banks can provide additional liquidity to domestic banks on their own national balance sheets, it is moreover not obvious that making a credit risk distinction between the ECB and national central banks in the ESCB is sensible for private investors. Certainly in both the Irish and Cypriot cases, the ECB has insisted that national central bank ELA also be granted the same preferred creditor status as the ECB has itself.