Why the European Central Bank Will Likely Shrink from Quantitative Easing
Given the low inflation and ongoing financial fragmentation of the euro area and the increasingly suggestive comments from the European Central Bank (ECB), the bank appears more willing than ever to apply additional monetary stimulus to the economy—without actually acting to do so. The talk even goes so far as to suggest that the ECB will embark on its own program of bond purchases known as quantitative easing (QE). But talk is cheap in Frankfurt. Those advocating such bold action should not get their hopes up.
The ECB made no changes to its interest rates in early January. Neither did it offer any new nonstandard monetary policy measures to combat financial fragmentation and low inflation in the euro area1 (0.8 percent in December 2013), which is well below the ECB's own target of close to, but below 2 percent. The ECB president, Mario Draghi, and the Governing Council instead offered more oral market intervention. The Governing Council in its monthly communique first "strongly emphasizes that it will maintain an accommodative stance of monetary policy for as long as necessary" while reiterating "our forward guidance that we continue to expect the key ECB interest rates to remain at present or lower levels for an extended period of time." The council also said it would be "monitoring developments closely" and was "ready to consider all available instruments." Finally it declared itself "determined to maintain the high degree of monetary accommodation and to take further decisive action if required."
Behind the Curve, but Not on the Verge of QE
In the transatlantic monetary tightening cycle, the ECB's language puts it behind the US Federal Reserve and Bank of England, which are now both getting close to their numerical unemployment triggers for raising interest rates. And Draghi was cheeky enough to use coded language—"all instruments that are permitted by the Treaty would be eligible for use by the Governing Council"—that many wishful market observers view as indications of impending QE. The argument occasionally heard is that Frankfurt just has to get over a forthcoming German Constitutional Court ruling to have the legal and political freedom to take the step toward further easing through QE. Regular QE (defined as unconditional large-scale purchases of government and government-guaranteed bonds) nevertheless remains a remote possibility.
But the ECB is too politically astute to time its policy interventions to a legal case in Karlsruhe, headquarters of the German Constitutional Court. Simply because QE has been somewhat effective in easing monetary policy in the United States, United Kingdom, and Japan at a time of zero nominal interest rates does not mean it is an efficient instrument for the ECB.
In the absence of eurobonds, the ECB lacks an obvious instrument through which to conduct QE. Some have suggested that the ECB buy a basket of euro area government bonds. But this step would risk some euro members' free-riding on such unconditional purchases. It would surely be legal for the ECB to do so, but that doesn't mean it would be politically savvy. The fact that there is no political will in the euro area for explicit fiscal transfers between member states makes it politically controversial for the ECB to engage in such basket purchases, which are obviously similar to regular fiscal transfers. And this is especially so now, when austerity fatigue is increasing across the euro area and a new electoral cycle in several countries approaches in 2015. Having staunchly insisted on fiscal austerity until now, it seems implausible that Frankfurt would suddenly change course.
In addition, there is the issue of the problem that QE is supposed to solve. The rationale of the Federal Reserve and Bank of England has been to nudge risk-averse private investors away from risk-free assets like government bonds and into more productive equity-type assets. With 18 different fiscal jurisdictions in the monetary union, however, the ECB faces a segmented risk-free asset space. Its principal policy challenge is to overcome fiscal fragmentation, which means overcoming private investors' aversion to investing in peripheral euro area government bonds. The Fed and the Bank of England are trying to wean private investors from risk-free government bonds, whereas the ECB has the opposite problem of trying to get them interested in "national risk free assets" in the periphery. Outright purchases of government bonds are obviously not the best way to lure competing private investors back into peripheral government markets.
Recently, the ECB's policy of forward guidance—its promise to keep interest rates low for an extended time—has had a positive effect on peripheral government bond markets. Ireland placed a €3.75 billion 10-year bond with private investors at a yield of 3.543 percent on January 7, after receiving orders for more than €14 billion from more than 400 investors. Portugal placed a €3.25 billion 5-year bond with private investors for a yield of 4.657 percent on January 9. It had orders of more than €11 billion from 280 investors. [pdf] Evidently, the hunt for the very interest yield that ECB's (and other central banks') forward guidance is intended to deny bondholders is now so strong that peripheral European countries have relatively easy access to private markets.
Whether this benign market situation lasts for Ireland, Portugal, and others as the Federal Reserve tapers and the Bank of England revises its forward guidance is not knowable. But from the perspective of the ECB, the decline in sovereign peripheral primary market yields is a welcome signal of an impending reversal of the euro area's financial fragmentation. Some private investors may now be piling into peripheral bonds in the expectation that the ECB will soon begin buying, driving up the price, and yielding a profit. If so, such investors would have been expertly manipulated by Draghi.
The decline in peripheral yields means at least that differential sovereign spreads are narrowing. The ECB's upcoming asset quality review (AQR) or stress test must now go further and eliminate specific bank uncertainties and counterparty risks. Meanwhile, the ECB is unlikely to move toward QE in the face of declining peripheral sovereign yields.
Yet a central bank with as broad a mandate as the ECB has can still buy anything else it wants. It is only legally denied the option of buying government bonds on the primary market, for example. As Draghi keeps repeating, a number of alternative options are available to deliver additional monetary stimulus. The ECB need not be trapped by what other central banks do. It could lower interest rates further toward zero. It could implement a negative deposit rate or accept more private credit risk onto its balance sheet. It could also buy securitized loans to small and medium enterprises (SMEs) or corporate/bank bonds (with or without a government first loss guarantee).
The ECB could conduct additional targeted long-term refinancing operations (LTROs), ensuring that cheap liquidity is channeled toward the nonfinancial sector and away from government bonds. When the ECB becomes the euro area bank regulator, it may find such a goal easier to achieve, even if that would blur monetary policy and banking regulation. Finally, not being bound by the policy precedent of other central banks, the ECB might create an entirely new tool to fit its current objective, as it has in the past.
Still, in 2014, the threshold for major new ECB policy initiatives beyond the AQR/stress test challenge will be high.
1. The ECB's data for the coefficient of variation for bank (monetary financial institutions) interest rates on large loans to the nonfinancial sector in the euro area in the latest month available (November 2013), more than €1 million for new business purposes, show that the coefficient rose marginally from October 2013 to near record high levels of 0.34 in November. However, the interest rate variation rose only for loans up to a duration of 5 years while falling for longer duration loans. For most loans in the euro area, interest rate variation remains at near record high levels. These data are calculated as a weighted average (by corresponding business volume) of the euro area countries' interest rates. While changes in the weights from changes in business volumes are possible, the variation comes from differences between the interest rate levels in different euro area countries. In short, the higher the coefficient of variation of bank loans, the more broken the monetary transmission mechanism is. See data at http://sdw.ecb.europa.eu/browse.do?node=9484272.