Rash of ECB Comments--Separating the Noise from the Signal

There is a battle within the European Central Bank.  Some want to take stronger action.  Others do not think it is necessary.  It is not just a matter of counting up who is on what side of the issue.  It is not simply about majority rules.  The ECB seeks consensus.  

Although the ECB was criticized by many investors for not taking action in March or April, there has been an evolution of the ECB's position.   There has been an attempt to play up the possibility of quantitative easing.   Draghi seemed to emphasize that there was unanimous support for it, within its mandate, if needed to arrest deflation.  

A German paper leaked news that numerous models of QE have been tested, including one that includes purchasing up to 1 trillion euros of bonds over the course of a year.  The various tests suggested that QE could lift inflation by an inconsequential 0.2% or as much as 0.8%.   

However, at the same time, the clear implication from ECB officials is that 0.5% increase in March was a distortion and not the true signal of price pressures.  The unwinding of the Easter is expected to lift April's harmonized measure back to the 0.8%-0.9% area.  This would suggest that from the official point of view, the threat of deflation is not imminent. 

This was clearly the sense of a couple of ECB officials earlier today.  Mersch noted that QE is a theoretical concept,nband implementation is a different story. More importantly, the BBK's Weidmann further seemed to soften the threat of QE.  He denied that he had changed his position.  Weidmann explained that his benchmark is the legal standing of the policy, whether it is the OMT, SMP or QE.  If there is a significant under-shooting of inflation, the ECB will consider what instruments remain at the ECB's disposal, given its mandate.  

As is well appreciated, there are important political and legal obstacles to buying European sovereign bonds.  Assuming that the prohibition against monetizing debt can be overcome,  it is not clear what bonds the ECB should buy.  If it were to buy bonds in line with the GDP weighting of a country, the ECB would be buying a lot of German and French bonds.  This could see the spreads with the periphery widen, which weakens the transmission mechanism.  If it buys mostly peripheral bonds, as the SMP operation, it would be particular controversial and would renew concerns about the quality of the ECB's balance sheet.  

One way to pursue QE within the ECB's mandate would be to buy bank bonds rather than sovereign bonds. Yet, there are numerous technical difficulties.  The ECB's annual report, released today, indicates that despite the relaxation of the associated standards, banks reduced their use of asset backed securities for collateral with the central bank.  

Last year, the ECB eased the eligibility criteria (required only two single A ratings) and reduced the haircuts.    The ECB denies that there is a short of acceptable collateral in the Eurosystem.  The amount of collateral posted with it, fell last year, while the average amount of marketable assets the ECB would accept as collateral rose 3%.  

A sovereign-based QE would be easier to scale.  There may not be sufficient bank bonds backed by lending to households and small and medium size businesses.  These would have to be created, and recall loans to households and SME have been falling for nearly two years.  

We have suggested that given the legal and technical obstacles to buying European sovereign bonds, and the limited supply of ABS, the ECB ought to consider buying foreign bonds.  This is what the Swiss National Bank did prior to putting cap on the franc. A IMF staff paper out today suggests the SNB efforts, which included "heavy nonsterilized purchases of foreign exchange" was deemed successful.   From the ECB, it would look like intervention, which is why after considering such a course, the Japanese government backed away from it.     

The ECB would, in effect, sell euros and buy dollars and then use those dollars to buy US Treasuries or Agencies.  This would increase the ECB's balance sheet and boost money supply growth.  It would weaken the euro, which Draghi (and others) have argued is exacerbating the fall in inflation and is jeopardizing the economic recovery, which remains "weak, fragile and uneven."

France's Coeure, a member of the ECB's executive board, denied the need for QE today, but seemed to advocate lower interest rates.  The repo rate is at 25 bp.  It seems unreasonable to think that a 10 or 15 bp rate cut would result in any significant change, in conditions.  The lending rate, which is the upper end of the policy rate corridor, sits at 75 bp.  We have argued that this can be reduced, and it would help reduce the volatility of EONIA.  The deposit rate stands at zero.   The ECB has threatened a negative deposit rate for many months now, saying that it is technically ready.  However, such a move is unprecedented and could potentially be very disruptive to money markets, investors and businesses. 

There also seems to be a divide at the ECB about what would trigger a new policy response.  Weidmann and Knot seemed to play down the low inflation.  Knot repeated the claim that the decline in energy prices depressed prices, though we note that the core rate at 0.8% and has not been above 1% since last August.  Weidmann noted that the inflation differentials are part of the adjustment process.  

This means that falling prices in the periphery are instrumental in restoring competitiveness.  Spain is the example here.   The preliminary March CPI stood at -0.2%, yet the survey data and today industrial output figures (2.8% year-over -year in February from 1.1% in January) showed the fastest pace since late 2010. 

There are some members of the ECB, like Draghi himself, who may play down the risks of deflation, but appear just as concerned about "lowflation".  They want a lower bar for QE.  At his press conference last week, Draghi revealed that a situation of stagnation with an extended period of low inflation was his main concern and one, he said, was already happening.  

Draghi is coming to the US for the IMF meetings this week.  He is expected to hold a press conference at the end of the week.  He is unlikely to make any new revelations there, but he can be expected to reiterate his general thrust.  It will underscore the importance of the April CPI.  The flash report is due April 30.  

The Swiss CPI for March, using the EU's harmonized measure, did not show the distortions that ECB officials believe infected the its reading.   Swiss inflation rose 0.6% on the month.  Still, assuming ECB officials are correct in anticipating a rise in April's CPI, it means that the next opportunity for ECB action may not be at the early May meeting, but the early June meeting.  We think that the coming weeks will see more of this seeming back and forth, as Draghi tries to mold a consensus for additional action.