What is the ECB to Do?

The European Central Bank meets tomorrow.   The focus is on the details of the asset-backed securities and covered bond plan that was announced last month. 

There are three key issues related to this new initiative:  What instruments will be purchased,  how much will be bought, and how long will the purchase program last?

The ECB will buy the safest tranche of the asset-backed securities.  The initial proposal that it could buy riskier tranches if guaranteed by national governments was quickly rebuffed not only by Germany, which has been critical of the purchase plan, but also France. 

Since the crisis erupted several years ago, the ECB has reduced the quality of the assets it will accept as collateral, including ABS.   Greek and Cypriot ABS still does not meet even these relaxed criteria.  There was a report this week that intimated an effort to make an exception of these two countries.  However, this seems unlikely as such exceptions are not fair and would probably not have sufficient support.  

Indeed, it could have very well been an intentional leak to toughen the resolve of German and creditor nation resistance. Recall that the decision to cut interest rates last month and the purchase program was not unanimous.  Draghi referred to it as a "comfortable majority".  This does not sound as if Germany was the sole dissenter.  

After the low use of the new Targeted Long Term Repo Operation facility,  there was initially some thought that this would increase the pressure on the ECB to "shock and awe" with the "modalities" of its asset purchase program.  A Reuters polls found a consensus expectation that the ECB would buy 200 bln euros of ABS and covered bonds over the next 12 months.  In a poll shortly after last month's ECB meeting, the consensus was for a 300 bln euro program. 

We see some risk that the ECB does not announce the size of its purchase program.  This would maximize it operational flexibility.  Once it announces the criteria of its purchases, the market can deduce the potential size.  This is true of covered bonds as well.  The prior two covered bond purchase programs were 40-60 bln euros, which would be the lion's share of the outstanding supply.  

One significant wrinkle is that ABS and covered bonds have been used extensively for collateral at the ECB.  For example, banks retain part of the covered bonds, but these are used as an emergency liquidity backstop and the banks may be reluctant to part with these.  The weakness of the housing market through much of the eurozone  and the asset encumbrance rules, argue against a surge in new supply of covered bonds. 

Draghi had indicated desire to lift the ECB's balance sheet back toward 2012 levels.  We have cautioned against making a fetish of this target.  It is not clear that it is an official policy target; more a desire, perhaps, than a commitment.  Still, some argue that this is not quantitative easing, as if quantitative easing has an agreed upon definition.  In the US, for example, Bernanke did not call the Fed's long-term asset purchases quantitative easing, but credit easing.  

Some argue that to qualify as QE, sovereign bonds need to be purchased.   The Bank of Japan buys government bonds but also buys REITs, ETFS, and corporate bonds.  The different policy responses in among the major economies is partly a function of different types of capitalisms.  The US and UK, for example, rely more on markets to distribute capital, but Japan and the euro area remain bank-centric. 

Not only is the definition of QE not agreed upon, but its purpose has varied.  When long-term assets were initially purchased, it was to alleviate financial market stress by pushing down interest rates and displacing investors out of risk-free assets.  Its goal was later broadened to include resisting deflationary impulses, and then used to stimulate the real economy. 

The goal of the ECB's asset purchase plan is to arrest disinflation, re-anchor inflation expectations, and help boost lending to small and medium businesses and households.   While Draghi, like all central bankers, are loath to limit policy options a priori, those looking for a hint that the ECB is considering a sovereign bond purchase scheme will likely be disappointed.  It is not just because of German (and creditor) opposition.  The ECB has overruled German objections several times, including the initial bond purchase plan (SMP), the Outright Monetary Transactions, and again with the recent rate cuts and asset purchase plan.  

It is not just the legal hurdles, as the market awaits the European Court of Justice ruling on the OMT, for which the Bundesbank's Weidmann testified against.   Weidmann himself previously indicated that under certain conditions QE might be acceptable.  There are non-political and non-legalistic reasons to be suspicious of a sovereign-based QE.    What is the point?  Eight eurozone members have negative 2-year yields, including Ireland and Slovakia.     Germany's 10-year bond yield is below 90 bp.  Italian and Spanish sovereign yields are at record lows though debt levels are at record highs. 

Of the ECB's challenges, high sovereign bond yields are not among them.  It is not clear that buying sovereign bonds will boost inflation.   The weaker euro may have a greater impact on boosting price pressures than lower nominal interest rates.  The link between sovereign rates and rates paid by households and SMEs is not very tight.  

During the Great Depression, when the US was also more bank-centric, the Federal Reserve dis-intermediated the banks.  They moved into the breach created by banks either unwilling or unable to lend.  The Federal Reserve lent directly to small and medium sized businesses.  While the ECB does not have that experience in its short history, some of the national central banks have made loans to businesses.  

In a larger sense, what ails the eurozone might not be amenable to monetary policy.  And the only reason that monetary policy is being over active is that fiscal policy is frozen.    The cult of austerity means that most countries do not have scope to use fiscal policy.  Those countries that have the scope, like Germany, do not have the will.  The grand coalition government in Germany has agreed to deliver a balanced budget next year.

The recent and sharp decline in the yen is expected to reignite the upward pressure on prices.  The decline in the euro may do the same for the eurozone.   Earlier this year, we suggested that the ECB should consider taking a page out of the Swiss National Bank’s play book.  When it wanted to ease policy, the SNB was constrained from a QE operation by the lack of sufficient domestic bonds.  It bought foreign bonds.

Rather than take the controversial step of buying member bonds, the ECB could buy foreign bonds.  It would not have to do a large size.  An announcement to buy a relatively small amount of Treasuries is well within the ECB’s mandate and would have a dramatic effect. 

It would likely annoy US officials.  The Treasury’s report earlier this year urged foreign officials not to buy US government bonds.  This, they argued, prevents the adjustment process to which the G20 are committed.  A weaker euro simply borrows (or steals, depending on your vantage point) growth from elsewhere.  It does not create the conditions for sustainable growth, the way that structural reform can.      However, if the  ECB’s foreign bond purchases were part of a larger commitment to pro-growth policies and structural reforms, it would likely be more palatable.