ECB surprises markets with interest rate cut and purchases of private assets: Round-up of reactions from around Europe

As we predicted might happen, the ECB surprised markets yesterday with the announcement of an interest rate cut and the purchases of private assets.

Open Europe’s Raoul Ruparel has a full analysis on his Forbes blog, where he concludes:

“In summation, Draghi surprised the markets with some bullish action. That said, I remain unconvinced that these programmes will do much to boost inflation, growth or even credit supply in the Eurozone. Importantly, the ECB is nearing the end of the actions it can take, and it is very aware of this. The onus has now once again been shifted to governments, with the expectations rising for action. For the first time since 2012, pressure is now really increasing for Eurozone governments to reassess the Eurozone’s institutional structures and take action to pool further sovereignty. Draghi may have come bearing gifts for markets but he came with further warning for governments.”

Needless to say, the fallout from the ECB's announcements has been widespread and varied. Below are some of the best reactions from papers across Europe. As one might expect, the German press was less than impressed with the policies unveiled by Draghi:

Die Welt’s Economics Editor Sebastian Jost describes the announcement as “Draghi’s last roll of the dice”, and claims that the ECB has demonstrated “an unusual passion for experimentation”. He also argues that “the ECB has now done pretty much everything which appears to be economically justifiable. Whoever wants a stable monetary union should hope that it does not go any further.”

Süddeutsche Zeitung’s Economics Editor Ulrich Schäfer describes the ABS as a “highly dubious innovation”, claiming that it resembles many of the financial products that contributed to the initial financial crash “when no-one could ultimately identify who had lent whom how much, and therefore who had assumed what risk.” He concludes that it is “ironic” that the ECB wants to give such products “renewed respectability”.

FAZ’s Economics Editor Holger Steltzner criticises Italy and France for delaying structural reforms in order to get more help from the ECB. He also argues, “Does the purchase of securities, which banks are struggling under the burden of, even come under monetary policy?...How can the ECB eventually return to normal? As soon as it increases interest rates, it will threaten itself with losses.”

Again as many would have predicted, the Mediterranean press took a more sympathetic view of Draghi’s decisions.

An editorial in Spanish daily El País argues that “the ECB hasn’t disappointed…[but] it’s equally necessary that the governments with sound public finances – and notably the German government – intensify investment and temporarily back greater flexibility in the necessary requests for public finances adjustment in the eurozone as a whole.”

The deputy editor of Spanish daily El Mundo, John Müller, makes an interesting point, “The enormous debt – both private and public – that has been amassed, is such a huge burden that it is surprising that no-one is addressing the problem seriously...Yesterday, Draghi only asked for help [from eurozone governments] in the form of fiscal measures and reforms, but not [in the form] of debt restructuring. In short, we don’t know if the monetary sorcerer has correctly identified the reason why we have lost the favour of the gods of growth.”

Columnist Jean-Marc Vittori writes in French business daily Les Echos that “the currency won’t be enough to save Europe”, and argues, “[There’s] no tenable monetary union without budgetary union. In a continent where the temptation to withdraw is growing, this appears to be a challenge. Nonetheless, it’s the condition for the survival of the euro.”

Italian Economics Professor Donato Masciandaro writes in Il Sole 24 Ore, “Draghi couldn’t have been clearer: the later the necessary fiscal and structural policies come, the less effective monetary policy will be…Such a decisive statement should make everyone reflect. The [European] Union is like a bogged-down machine. It has at least four traction wheels – currency, taxation, competition and labour – but only one of them is working. In such a situation, the machine risks going under.”

Italian journalist Danilo Taino writes in Corriere della Sera, “[Italian Prime Minister Matteo] Renzi is a lucky guy, since no [Italian] Prime Minister ever got this sort of help from the ECB. This means, however, that [Renzi] won’t be able to ask for anything else from Draghi. The ECB President has reached the extreme limit – except for a difficult, potential government bond-buying programme. From now on, everything is in the hands of governments.”

One interesting take away, particularly from the articles from around the eurozone periphery, is that there seems to be a renewed push for measures such as further budgetary union and debt-pooling. It looks as though there is a growing acceptance of the limitations of ECB action, and the continued flaws in the Eurozone architecture – something which we have long warned of.

ECB preview - Dovish Draghi to double down on easing?

The European Central Bank (ECB) holds its monthly meeting in Frankfurt today - the day after ECB President Mario Draghi's 67th birthday.

As usual, Open Europe's Head of Economic Research Raoul Ruparel has published a preview on his Forbes blog, explaining what we may expect from today's meeting.

Here goes:

Following ECB President Mario Draghi’s dovish speech at Jackson Hole last month this week’s ECB meeting has taken on new importance. This has been further enhanced by the recent Eurozone inflation data which put annual CPI at 0.3% in August. The headline figure hides some of the story with core inflation actually rising to 0.9% (from 0.8%) but the ECB’s previous inflation forecasts have begun to look increasingly out of line with reality.

However, those expecting a big move are likely to be a bit disappointed. As I pointed out last month, it is almost nonsensical for Draghi to unveil new measures before his previous policies have been implemented. I am thinking specifically of the TLTROs (targeted long term lending operations) the first of which will only be conducted on 18 September. Any big announcement now could undermine the predicted take up of these measures – which clearly remain the ECB’s preferred approach for injecting further liquidity.

That being said, these measures are unlikely to make much difference since the conditions for passing liquidity on to the real economy remain very loose. They are also very unlikely to appease investors and markets which have now come to expect some significant new easing. The two key options which are on the table for this meeting are:

1. A further interest rate cut: Many will validly ask, what is the point in a further cut now? Of course it would have little to no economic impact, however, it would once again signal the dovish bias of the ECB. It would also signal a clear shift in the ECB’s position given that Draghi has previously said rates are unlikely to get any lower than current levels. It becomes another mechanism to express his commitment to further easing. There also remains scope to make the negative deposit rate more negative, although there is a cap on this since, at some point, it will be cheaper for banks to simply hold cash than deposits with the ECB.
    
2. Purchases of private sector assets – specifically Asset Backed Securities (ABS): The ECB has long telegraphed such action and it is the next obvious tool at its disposal. Whether or not it will be announced this month or in the coming months is a bit of a toss-up. It seems the ECB is not quite ready to implement it yet and has made a big song and dance about the need to adjust regulations and definitions of ABS, which are yet to fully take place. Whenever it is announced, implementation is likely to be later this year to allow the negative deposit rate and TLTROs to have time to work. I remain sceptical on the effectiveness of this policy, which I have analysed in detail on the Open Europe blog. Ultimately, the market for the transparent ABS related to SME loans remains very small in Europe and focused in the core countries rather than the periphery (where this money really needs to flow to). For example, in Q1 2014, of the €18.5bn in ABS issued, only €1.6bn used SME loans as collateral. The ECB maintains that it can and will help create the market in this area, yet with this measure having been forecast for some time, you would expect there to have been some market response already.

As with many of Draghi’s press conferences, all of this will be weaved into a dovish speech including a few key trigger words for markets – few other central bankers are as adept in their communication. As for full blow Quantitative Easing on sovereign debt, this remains someway off in my mind and hurdles remain high. Its use will ultimately be tied into developments in the fiscal and political sphere, as hinted at in Draghi’s speech (more detail on this coming in a future post). The ECB will be loath to unveil QE, which it fears can only buy time, without further commitment to reforms, a clearer fiscal approach and developments on the structure of the Eurozone which such changes will entail.

Have borrowing costs in the eurozone periphery come down too far, too fast?

Over on his Forbes blog, Open Europe’s Raoul Ruparel asks: is there a bond bubble in peripheral Europe? The thurst of his answer is that, while there are good explanations for why costs have come down so far and so fast, they could certaintly have side effects, not least because people misinterpret the reasons for the move. The full post is here, but below are the key points:

What is driving this and is it a bubble?
There are three key factors at work here:

1. ECB President Mario Draghi’s promise to do “whatever it takes” to protect the euro combined with the unlimited bond buying policy of Outright Monetary Transactions (OMT) has driven borrowing costs down since mid-2012. This effect has been amplified by the expectations of further ECB easing, particularly some form of Quantitative Easing (QE), which would bring yields down even more.
2. There has been some success in terms of eurozone reform, particularly with the successful end to the Irish and Portuguese bailouts as well as these countries’ return to the markets, along with Greece. The eventual agreement on banking union and other aspects of trying to correct the structural flaws in the euro (although I believe it is far short of what is needed) has also contributed to the positive sentiment.
3. Possibly the most important factor though is the very low inflation in the eurozone (and even deflation in some countries). Over the past six months this has pulled the borrowing costs across the eurozone down.

This final point is driven home by looking at the rough and ready version of the ‘real yield’ on ten year debt in Europe (10yr yield minus HICP inflation). As the graph below highlights*, when this is done the UK actually borrows at a real rate which is 2% below Ireland’s.

Could this present a problem? (Hint: Yes)
While the process of collapsing bond yields in peripheral Europe is explainable it does still present some serious causes for concern.

• The huge demand for peripheral bonds does seem to have gone too far with respect to the economic fundamentals of these countries. Debt levels have continued to rise – exacerbated by low inflation – while many countries are barely posting any economic growth.
• More concerning though is that this creates very perverse incentives. Many governments can already be seen professing the success of their policies, citing falling borrowing costs and buoyant financial markets. In reality, these are much more down to the ECB and inflation effects mentioned above.
• The risk is that complacency seeps in (some of which can already be seen) and that the reform process in these countries stalls. Italy and France are prime examples of this. While the European Commission does have additional powers now to encourage further reform, when push comes to shove there is little it can do to force reform on an unwilling political class and population, particularly one with low borrowing costs.
• As detailed here, the banking union looks insufficient to break the sovereign banking loop in the eurozone. The efforts to improve the structure of the eurozone have slowed, the risk is they will grind to a halt until the threat of a crisis returns.
• The performance also looks strange relative to countries such as the US and UK which have always borrowed in their own currency for which they are solely responsible and have clear fiscal and central bank backing. Even with the changes to the euro structure and the ECB promises it’s hard to say that, in another crisis, the same issue wouldn’t arise with regards to a comprehensive lender of last resort (let’s not forget, the OMT comes with plenty of conditions and is limited in scope). Even though accounting for the inflation impact, the difference in risk between peripheral eurozone countries and the likes of the US and UK does seem to be being underestimated.

Ultimately, the crisis highlighted that too much price convergence without economic convergence and reform in the eurozone can actually be a bad thing, with resulting perverse incentives and negative outcomes. While the price action in peripheral bonds might not yet count as a ‘bubble’, investors and politicians would do well to remember these lessons when interpreting the record low borrowing costs.

Has the ECB actually moved closer to QE?

There has been a cacophony of comments from ECB members and ECB watchers over the past few days. However, the overriding view since ECB President Mario Draghi’s press conference last week is that the ECB has now moved a step closer to unconventional action such as Quantitative Easing (QE).

This is mostly down to two factors. First the following statement from Draghi’s presser:

“The Governing Council is unanimous in its commitment to using also unconventional instruments within its mandate in order to cope effectively with risks of a too prolonged period of low inflation…this statement says that all instruments that fall within the mandate, including QE [Quantitative Easing], are intended to be part of this statement. During the discussion we had today, there was indeed a discussion of QE. It was not neglected in the course of what was actually a very rich and ample discussion.”

Second, the FAZ report over the weekend that the ECB has been modelling the impact of a €1 trillion per year (€80bn per month) QE programme. While it suggested that such a programme would only raise inflation by between 0.2% and 0.8% (not a significant amount given the cost), the simple fact it is being modelled has been enough to give markets hope.

We believe QE or similar measures have become a bit more likely, but mostly because the market now seems to expect action and if the ECB is to maintain its credibility it will need to do more than simply talk.

That said, while there may be ‘unanimous commitment’ to using such measures when needed, it’s still not clear what the criteria are for such action and it is even less clear that all members of the GC agree on when such action would be needed. Draghi was pushed on this on the first question during the Q&A session, however, he never provided a direct answer.

Furthermore, much of the coverage has suggested that QE is in fact closer because the ideological opposition to such a measure at the Governing Council (GC) level has crumbled - although we're not sure that such a clear unified opposition ever really existed.

With this in mind then, it’s worth once again pushing the point that, in fact many of the issues with further easing are practical, political and/or legal rather than ideological at the ECB. We have previously analysed each measure in detail, below is a summary and links to all those posts:

Quantitative Easing (purchasing government debt)
We have detailed the issues extensively here (but also here and here). Draghi has hinted of these practical issues before, highlighting that they need time to design the programme and gather more information. Beyond political opposition in Germany and the legal limits to ECB financing governments, there is a clear problem in that the purchases would need to split according to the ECB capital key, meaning little would flow to the periphery where the deflationary forces are strongest. Add onto this the fact that QE in other countries has not been proven to boost the real economy or even bank lending as well as that it may exacerbate the squeeze on safe assets and it becomes clear that practically and technically this would be a very difficult step for the ECB to take and is not well suited to tackling the problem of low inflation.

Quantitative Easing (purchasing private assets)
See our detailed analysis here. The thrust would be to target purchases of assets which would help promote bank lending – the main one discussed is Asset Backed Securities (ABS), particularly ones made up of loans to the real economy. However, these markets in Europe are small and underdeveloped meaning the level of assets available and suitable for purchase would be minimal. The ECB has suggested it wants this market to grow but it’s tough to force such a move, especially in the short term.

Negative deposit rate
We analysed this option here. Since then the ECB seems to have made progress on the technical implementation of such a move. That said, the impact remains very uncertain. It could further reduce excess liquidity, force money market funds to shutter and force banks to pass costs onto consumers. On the plus side it could help weaken the euro.

A targeted LTRO (similar the Bank of England’s Funding for Lending Scheme)
Discussed, with other measures, here. A fairly simply option to take, however, given that there is already full allotment (unlimited liquidity at low rates) and banks have already repaid a lot of the previous LTROs there is no guarantee there would be any significant take up or that it would filter through to the full economy.

Ending sterilisation of the Securities Markets Programme (SMP)
A smaller measure, discussed in this post. While it would stop liquidity being drawn out of the system on a weekly basis, it’s not clear that this liquidity would flow to the real economy.

Further standard measures such as rate cuts and changing collateral rules
We rounded up such options a while ago here. Given that rates are already so low and that the transmission mechanism remains broken, the impact of such moves is likely to be limited to signalling intent rather than hoping for any significant return.

Overall, nearly all of these measures face quite serious practical, technical and/or legal obstacles.

Furthermore, it is unlikely that there is any consensus at the ECB GC level of when each measure is needed or what the triggers for such action are. The obstacles are also probably viewed to be different sizes by each national central bank. All that is to say, while it may have moved slightly closer, don't yet count on QE being much more than a last resort.

ECB stands firm but looks to wider measures

Over on his new Forbes blog, Open Europe’s Head of Economic Research Raoul Ruparel lays out his take on why the ECB decided to stand firm despite the apparent deflation threat,

“My feeling is that there are two broad reasons. The first being that the flow of data is mostly positive, and the second, more important factor, being that none of its tools are economically, politically or legally suited to tackling the low inflation environment in the eurozone.”

He concludes,

“All in all then, the tools at the ECB’s disposal are far from suited to helping push up inflation in the struggling countries and boosting lending to the real economy to help economic growth. This is not to say the ECB would never use them, but that are better suited to a deeper more acute crisis (such as a break-up threat) than the chronic long term malaise which the eurozone currently finds itself in.”

These are themes we’ve explored plenty of times on this blog so won’t rehash here.

But there were a couple of other interesting points to come out of ECB President Mario Draghi’s press conference though.

The first being his mention of a new dataset which the ECB is looking at, specifically the “the high degree of unutilised capacity” in the eurozone economy. This refers to the ‘output gap’, i.e. the amount by which GDP in the eurozone has fallen below potential GDP. As you might imagine, estimating such a gap is fraught with difficulty and estimates are notoriously revised retrospectively (for example before the crisis few economies were seen performing above potential despite huge financial, real estate and debt bubbles).

Why is this important? Well, it could be the first step towards a more firm GDP target on the part of the ECB. Admittedly, it’s a small step and a full GDP target is unlikely but it could be an interesting shift for the ECB which has traditionally focused more on inflation, money market and private sector survey data (such as the PMIs). As Draghi himself said, it also shows that monetary policy will stay looser for longer, even if the data improves, due to the large gap between actual and potential GDP. It will be interesting to watch how this one develops over the next few meetings and whether the ECB decides to put any more emphasis on this measure.

ECB preview - ECB may take limited action but shy away from serious intervention

As we noted last month, a lot has been pinned on the March ECB meeting, with the release of new data potentially facilitating further easing action.

But on the eve of the meeting, analysts remain split, although the sense is that the pressure for significant action is easing. February’s inflation data came in above expectations, with core inflation (removing the effect of short-term moves in energy and food prices) actually at 1% - still very low but well above expectations. We’ve also seen positive PMIs (indicators of private sector business activity) across the eurozone and in some of the struggling countries, although France remains behind the curve.

With that in mind, it looks as if the ECB will shy away from taking a major decision on Quantitative Easing or a negative deposit rate. These remain drastic actions which the ECB is clearly unsure about, and with good reason. It’s not clear what the side-effects would be of such action or that it would actually feed through to tackling low inflation in the periphery or boosting lending to the real economy (and therefore economic growth).

There are a few other options on the table. Another, more targeted long-term lending operation (LTRO), or purchases of private sector assets, probably packaged bank loans (asset-backed securities). These are possible and more likely than the above, but for reasons discussed before, would also be quite a big step by the ECB.

The most likely options remain a token rate cut (i.e. one without an accompanying cut to the deposit rate), a further extension of the unlimited fixed rate liquidity provision and the end to ECB sterilisation of the Securities Markets Programme (SMP) bond purchases. We have outlined before that, at this stage, a rate cut makes little difference as the transmission mechanism is broken, at least to the areas where the impact of the cut would like to be felt. Extension of the liquidity provision is also broadly inferred and was always expected to go on as long as is needed, in line with the forward guidance given.

We’ve yet to discuss the end to sterilisation, so we lay out a few points below.

As a recap, the SMP was a programme launched in 2010 to purchase government bonds on the secondary market and bring down borrowing costs for certain countries (which were hampering the transmission of monetary policy). The sterilisation process sees the liquidity introduced by these purchases absorbed by the ECB, through the issuance of corresponding amounts of one week fixed-term deposits with an interest rate of 0.25%.

ECB SMP sterilisation total amount (€m)

Why take this measure?

• The idea is that ending the sterilisation would free up the €175bn in liquidity currently pledged to the ECB. This will counteract the recent decrease in excess liquidity in the eurozone and should encourage banks to lend this money out rather than simply posting it with the ECB.
• From a political perspective, this is also one of the least controversial actions since it has been endorsed by the Bundesbank and should be fairly easy to get support for at the ECB Governing Council.

Will it have any impact?

• It is unclear, but we are not overly hopeful. As the chart to the right (courtesy of Commerzbank) highlights, the earlier tensions in money market rates have eased. This means the impact will be limited.
• Ultimately, it depends on what banks decide to do with this money. The ECB deposits were a very safe investment with a decent return given the ultra low rates around at the moment. Our feeling is that banks will want to continue to search for equally safe assets rather than take on much more risk for a similar return over a short period. This could actually acerbate the demand for quality short term assets, particularly core ones, in the eurozone.
• Despite some failings in the sterilisation (shown by sharp deviations in the graph) demand has been fairly solid, although whether this is due to demand for safety or a decent return is unclear.
• The fixed-term deposits are also eligible as collateral for the ECB’s lending operations. It’s not clear if they have been used for this purpose, but if they were, this could further limit the impact in terms of boosting liquidity.

Ultimately, ending SMP sterilisation would be a token compromise measure. Its greatest use is probably as an indicator of an on-going willingness to ease if needed, and of the ability to compromise on the issue from the Bundesbank side. 

IMF weighs in on the debate surrounding the ECB

There’s been another interesting report put out by the IMF today in the form of its ‘Article IV consultation on the euro area’ (essentially an economic assessment of the eurozone).

The IMF was particularly vocal on the role of the ECB stating:

“Because inflation is low and falling, the ECB has room for lowering rates, and deploying additional unconventional measures would relieve severe stress in some markets.” 

They’re not wrong there, any conventional inflationary pressure for the eurozone as a whole is definitely abating. But the policy implications of such a move are important. The IMF itself puts forward some alternatives, including:

Further liquidity provision. This could encompass additional multi-year LTRO facilities, coupled with adjusted collateral requirements, if needed—including a broadened collateral base and/or a lowering of haircuts—to address localized shortages. The associated credit risk to the ECB would be manageable in view of its strong balance sheet and high levels of capital provisioning. Nevertheless, one of the disadvantages of the LTRO facility is that it tends to strengthen sovereign-bank links (see Box 5).

Quantitative easing (QE). The ECB could achieve further monetary easing through a transparent QE program encompassing sizable sovereign bond purchases, possibly preannounced over a given period of time. Buying a representative portfolio of long-term government bonds—e.g., defined equitably across the euro area by GDP weights—would also provide a measure of added stability to stressed sovereign markets. However, QE would likely also contribute to lower yields in already “low yield” countries, including Germany. 

As you’ll notice both recommendations come with clear caveats – strengthening the sovereign banking loop with the LTRO and the fact that QE would need to be spread across the entire eurozone. We’ve discussed both at length on this blog and in our research but a refresher never hurts.

The LTRO has certainly driven the sovereign banking loop much closer, engraining this connection at the heart of struggling economies (far from ideal) while encouraging the nationalisation of financial markets once more. All this prompted the well-known and incredibly complex banking union discussion. The IMF also notes a further problem with more LTROs, asset encumbrance. A complex issue but essentially banks are running short of quality assets to post as collateral to borrow from the ECB (see graphic below). So even if further LTROs were offered they may not be able to take advantage of them. If the ECB went down this route and faced this problem it would have little choice but to widen its collateral rules or reduce the valuation ‘haircuts’ (which decide how much banks can borrow against certain collateral) thereby taking even greater amounts of risk onto its balance sheet.

 
In terms of QE we’d point you to our report from December and the table below. Ultimately, it would have to be a huge spate of QE to provide enough of a boost to the countries in trouble, but that would also create a huge amount of money flowing into countries such as Germany (which is already concerned about an asset and property bubble).

We’ve argued before that a more significant role in the crisis for the IMF wouldn't be the worst thing in the world. Generally it has provided a more realistic assessment of the situation. Unfortunately, in this case, the problems outlined above are only the technical ones relating to a greater role for the ECB, the political obstacles remain almost insurmountable in the short term. As with the UK government, we’d recommend the IMF engage but avoid spending too much time of policies which are politically nearly impossible and technically challenging.

ECB sterilisation fail

The ECB yesterday failed to fully sterilise its purchases of government bonds under the Securities Markets Programme (SMP).

A quick recap - the sterilisation is designed to remove the same amount of liquidity from the financial system as the ECB introduces from its purchases. This stops the ECB from engaging in Quantitative Easing (QE) and allows it to stay in within its mandate by avoiding financing member states directly. This is done by taking on one week fixed term deposits.

This is definitely a strange occurrence and may have some important follow on impacts, especially if it happens again in the near future. Here are a few of our key thoughts:

- ECB failed to absorb the necessary liquidity to sterilise its purchases of sovereign debt. Its target was €203.5bn but it only succeeded in taking on deposits of €194.2bn.

- The shortfall of €9.3bn is not huge but is large enough to be worrying, especially since it basically amounts to the level of bond purchased over the past week.

- This is not the first time the sterilisation has failed. It did so previously (and to a larger extent) but was able to get back on track. At that time the failure was likely due to banks preference to place liquidity/deposits elsewhere to gain higher returns.

- This failure is more surprising, since in times of uncertainty banks are keen to stash funds within the safety of the ECB.

- So why might it have failed? It could be that liquidity is so short and times so uncertain that banks prefer to keep the funds on hand than commit them to a fixed term deposit of one week. This makes sense given the eurogroup and ecofin meetings today and tomorrow as the situation could change with the outcome of those meetings.

- It is also concerning that given the amount of liquidity that banks are draining from the ECB lending operations, there is still not enough demand for the one week fixed term deposits.

- This all raises questions over whether the ECB is reaching some technical limit for sterilisation. It has long been rumoured that there is a limit to the amount of liquidity which the ECB can suck out of the system at reasonable rates. There could come a point where the banks simply do not have the liquidity at hand to fill such huge need for deposits, especially given that their funding is already spread so thinly during the crisis.

- Future sterilisations will be interesting, since previously the ECB has always rebounded quickly and managed to meet its target.

So, in itself this is not a huge event but it definitely raises some interesting questions. Not least on the debate surrounding the role of the ECB. If some technical limit is reached (from the failure of sterilisations) it will force the issue of whether the ECB can engage in unsterilised bond purchases, essentially QE. At that point, as we have pointed out before, it is likely that the ECB and Germany will have to make a fundamental decision over whether to either continue the bond purchases, abandoning their core monetary principles, or stick to their guns and wind down the purchase programme altogether.

Just another small indication that the endgame for the eurozone may be approaching, as if we didn't have enough already...

Could the ECB actually perform QE even if it wanted to?

Given the stock market free fall and bond market turbulence we’re seeing, the question over whether the ECB could actually embark on an effective round of Quantitative Easing (QE) has become a pertinent one. We’re not so sure it could (leaving aside the broader questions over how effective QE would be in any case [see US economy for details]).

First off, any increase in the monetary base of the eurozone requires the approval of the ECB Governing Council (GC), whether it is in hard currency (directly printing money) or electronically creating money (how QE is usually done). The GC is made up of the ECB executive board and the heads of each eurozone national central bank (NCB). The vote would be decided under QMV votes are weighted according to the level of capital shares each country has in the ECB. A majority is defined as two thirds of capital and at least half the members of the GC. So it would be a close run thing, but there could easily be enough opposition to halt any QE plan.

Secondly, even if any QE were approved, it would need to go through NCBs. The usual QE process is to deposit the funds directly into the reserve accounts which banks hold with a central bank or to purchase assets (probably government bonds) they hold via these accounts. Since these accounts do not exist directly with the ECB it would need to go through the NCBs (as per usual for monetary policy). So, all NCBs would need to enact the QE and to maintain the stability of the euro (so that new money is not just being created in excess in one area) the amounts would have to match up to the defined shares of the eurozone monetary base.

This means that Germany would actually have to enact a large percentage of the QE, in an economy which is growing solidly and is already becoming worried about inflationary pressures (particularly at current interest rates). Although, German domestic demand could do with a boost there is likely to be some inflationary effect of the QE if the transmission is effective. Even with the heavily interconnected banking sector in Europe it is unlikely that, given the current market pressures, money would easily flow around Europe to where it is most needed. Many banks continue to remain undercapitalised and are seeing profits squeezed by rising non-performing loans and the sovereign debt crisis. These are general problems with QE admittedly but are exacerbated by the structure of the eurozone making QE an ineffective tool in the eurozone.

As of right now, we still might be some way from an ECB bout of QE (although it’s closer than a few days ago). But, the ECB’s inability to perform what can be seen as a key tool in a central bank’s armoury highlights the structural problems for the ECB within the eurozone. In the longer term this could easily feed into market fears as we have been seeing with the heavily linked issue of lender of last resort.