ECB debate comes full circle back to QE again - but substantial obstacles remain

As with many things in the eurozone crisis, we have now come full circle in the discussion of one part of ECB policy – the prospect of Quantitative Easing (QE).

The debate over ECB QE was had when the crisis was at its peak. The motivating factor then was ensuring the euro stayed together. Now the motivating factor is low inflation/fear of deflation and low growth. The ultimate conclusion back then was that QE is not the right policy for the ECB (compared to the Fed or the BoE) for a number of practical and political reasons.

Despite the current motivation behind the debate being different, we think the key constraints still hold, while other issues over the effectiveness of QE have also come into play. Our previous thoughts are here. Below we restate our points and add some new insights.

Hard to target QE on the necessary sovereign debt: As we stressed in our previous post and note on this, any QE in terms of direct primary market purchases of eurozone sovereign debt would have to be shared out according to each countries share of ECB capital – i.e. Germany and France would see the large majority of purchases. This significantly limits any real benefit in the periphery and could worsen the crunch for safe assets in the eurozone with the price of core eurozone sovereign debt being driven even higher (and the returns going further down). The hope would be that this would spur investment in the periphery countries but given the investment patterns in Europe and the upcoming stress tests, it’s clear that demand for periphery debt remains separate from demand for core debt.

QE is very different to OMT: The exact constraints for OMT remain ill defined, but what we do know is that any purchases will be limited to short term (below 3 year maturity) debt on the secondary market, will be subject to the strict constraints of a bailout programme and the purchases will be sterilised.  What form a QE programme would take is also unclear, however, it is likely to involve significant and widespread purchases which come with no conditions and are not sterilised. 

QE on private assets might have little impact in Europe: Unlike the US and even the UK, the European market for securities is far less developed. Furthermore, the corporate sector relies much more heavily on bank loans for funding than on debt issuance (see graph to the right). If the ECB decided on a QE programme to target different securities, the impact on the real economy would be limited by the structure of these markets. This point is driven home by the graph to the right below, which highlights the broad breakdown of assets in the eurozone - significantly dominated by government debt. The ECB could purchase mortgage backed securities, which is one of the more developed markets. However, a significant chunk remain non-performing (or close) and are opaque in terms of what is included inside them and what their true market price is. In all likelihood any purchasing of private sector assets would mostly be a boost to bank balance sheets, however, unless it is sufficient to completely reverse their deleveraging and kick start lending it would probably do more than push up asset prices.

Political obstacles are significant: The programme would need approval in the ECB’s Governing Council. With a quarter already known to be against last month’s rate cut, opposition to such a significant step could grow. Even if it got through the fallout in terms of divisions within the ECB and the political blowback from within Germany could create serious problems for the eurozone. Bundesbank President Jens Weidmann even said earlier today that the ECB should not take further easing steps in the near future after the rate cut.

The overall impact on the real economy is far from clear: the discussion over this point in the US and UK has been substantial, with no clear winner. While QE did likely help to avert a deeper crisis, particularly in the short term, the fact is that there is no clear link between higher inflation or higher growth and asset purchases of the central banks.

For these reasons, we believe QE will be a very last resort for the ECB. It is practically and politically difficult. That said, it still seems like further easing is very much being considered. See for example the Bloomberg story today about the very real possibility of a negative deposit rate (which has weakened the euro significantly). Such a move would itself of course come with drawbacks and difficulties, but we’ll leave them for another post.

Eurozone inflation hits its lowest levels for three years

Eurostat yesterday released its latest inflation statistics and the data for the eurozone provides some food for thought.

Inflation reached its lowest levels (1.1% on an annual basis) since February 2010. This might seem surprising on the surface given all the talk of a eurozone recovery and a turn around. Why hasn’t inflation followed? Well, generally inflation is a lagging indicator and therefore any recovery will take some time to feed through to prices and wages. However, as the graph below suggests, there is more at work here.

There has been significant disinflation (falling inflation but not negative inflation, which is deflation) in the eurozone and more importantly in the PIIGS. For all the talk of internal devaluation in the eurozone it has taken some time to feed through to the Consumer Price Index (CPI). Due to factors such as indirect tax increases and sticky prices and wages, it has taken some time for the impact to be fully felt – now that this is beginning to happen it is unlikely to stop immediately and could carry on for some time.

The data also shows that because of the effect described above, inflation in the PIIGS is diverging from the rest of the eurozone somewhat and particularly from the stronger countries in the north.

What does this mean for the ECB?

The FT has a couple of pieces today discussing this, calling on the ECB to do more to tackle the disinflation in the eurozone. While inflation is clearly well below the ECB’s target, the current nature of the inflation does present some issues for ECB policy.

• Firstly, there is the standard one size fits all conundrum – as inflation plummets in the PIIGS it remains stable in the north and threatens to increase as these countries post higher levels of growth. Adjusting the policies to suit these countries more could prompt unwanted outcomes in the stronger countries. Politically, it’s also worth remembers just how wary Germans are of inflation, as we highlighted recently. Finding the correct line between these two camps is incredibly tricky for the ECB.

• Secondly, while the struggling eurozone countries could use a boost in demand, the ECB may struggle to find the necessary targeted approach to do this. One measure which has been widely mooted is another long term refinancing operation (LTRO) to help boost liquidity in the market. However, as the graph above shows, there was no boost in inflation from the previous rounds, despite it totalling around €1 trillion. This is largely because the money did not filter through to the real economy and therefore did not impact consumer price inflation. Although things are improving there is still plenty of fragmentation in the market and loans to the real economy continue to fall in the PIIGS.

• This point also applies more generally in our view in terms of the tools at the ECB’s disposal. As we discussed at length here, although the ECB can do much to stop the break-up of the euro, it has fewer tools to help promote economic growth in the current circumstances, particularly in specific economies.

• In our view disinflation is not such a risk for many of these countries, in fact many need to see reductions in prices and wages to help boost their competitiveness, although it does of course have knock on impacts for their already flagging GDP growth. That said, deflation is a bigger risk because these countries have such large debt to GDP levels, which would only be exacerbated by deflation – although for countries such as Greece the need for further debt relief is already very apparent so the marginal impact of deflation is smaller.

All in all then, low inflation in the eurozone seems here to stay for some time due to the periphery pulling the average down, even if a fuller recovery eventually materialises. This will create some new issues for the ECB to deal with, however, given the divergence between countries it may well struggle to find the tools to have a big impact on this.

Conflict of interest (rates): clamour for ECB rate cut grows but Germany remains wary

The last few days have seen a shifting of consensus in the ECB rate cuts debate.

Recent economic data in the eurozone has been particularly bad, with private sector activity slowing more than expected. However, potentially more importantly, this effect has been seen in Germany and some of the stronger northern countries as well.

In response to this data most banks and analysts shifted their expectations and now forecast an ECB rate cut in May or June.

The thinking goes that, a slowing economy in these countries (and therefore lower inflation) will give the ECB more scope to cut rates without fear of it having disproportionate effects on the stronger economies. After all, the ECB is meant to find a balance that suits all countries (although it rarely does, hence the flaw of one-size-fits-all monetary policy).

As always on central banking issues though, Germany remains the key player.

German Chancellor Angela Merkel has now waded in to debate about possible ECB action. Speaking at the conference organised by Sparkassen association this morning, Merkel said:

"The ECB is obviously in a difficult position. For Germany it would actually have to raise rates slightly at the moment, but for other countries it would have to do even more for more liquidity to be made available and especially for liquidity to reach corporate financing."

"If we want to get back to a bearable interest rate level, then we have to get over this internal division of the euro zone."

In a country where central bank independence is worshiped, politicians usually stay well clear of commentating on monetary policy, so Merkel's comments are quite extraordinary. Perhaps they were prompted by increasing noise coming out of the French government over what it sees as the need for the ECB to take a more activist approach, despite a genetlemen's agreement between the two governments not to discuss ECB policy in public.

German ECB board member Joerg Asmussen also weighed in yesterday saying:

"Monetary policy is not an all-purpose weapon for any kind of economic illness…Due to impaired monetary policy transmission, the pass-through of rate cuts to the periphery would be limited, and this is where they are most needed.

At the same time, rate cuts would further relax already unprecedentedly easy financing conditions in the core. This is not per se a problem – but interest rates that are too low for too long can eventually lead to distortions. In particular:

• to a misallocation of resources, which ultimately leads to lower potential growth,
• to excessive capital inflows into a number of emerging economies with exchange rate effects and credit risks,
• and to reduced incentives for governments, banks, and corporates to adjust."

For numerous reasons, it seems that a rate cut should not be taken for granted after all. Asmussen is  right that given the broken transmission mechanism and market fragmentation, any cut will have limited effect on the economies where it's meant to provide a boost. But more importantly, there is still a view in Germany that lower rates could have a harmful effect particularly by pumping up an asset and property bubble – similar to those seen when newly low ECB rates were introduced in the south during the euro's creation.

That said, the wave of voices calling for some ECB action is growing, particularly given the wider debate on austerity. It will be tricky to balance this with the demands of the northern countries.

Once again the ECB finds itself stuck as the main player in an increasingly political debate.

When ideology meets economic reality (Part II): Bundesbank says EU financial transaction tax could make banks more reliant on cheap ECB money

As was made evident by the internal memo about the EU financial transaction tax (FTT) - that we exclusively published yesterday - there are plenty of concerns amongst the supposed champions of the idea.

Today, another heavyweight institution raised the alarm: Die Bundesbank.

This could come across as a niche issue, as with most central banking issues. But as with most central banking issues it could also be of vital political importance in Germany.

As we noted in our flash analysis on the UK’s FTT challenge last Friday, the proposal could have a worrying impact on ECB monetary policy:

Increasing banks’ reliance on cheap ECB cash: With central bank lending exempt from the FTT but the market channels to obtain liquidity hit hard, the FTT actually provides a perverse incentive for banks to borrow cheap money from the ECB and central banks. This runs completely contrary to efforts in the Eurozone to get banks off ECB liquidity and could instead further entrench market fragmentation.

This is a point which has been rarely made in the FTT debate but whose implications for Germany - already deeply worried about weak banks over-reliance on cheap ECB funding - could be huge. Sure enough, Bundesbank President Jens Weidmann today raised concerns over this very issue. In a speech in Dresden, he said:

The introduction of the tax has basically been decided but the unintended side effects could be considerable: In its currently envisaged form, the tax will cover asset-backed money market funds, so-called repo firms, and significantly damage the repo market. However, the repo market has a central role in ensuring the equalisation of liquidity between commercial banks.

If it does not function correctly, the corresponding institutions are diverted onto the Eurosystem, and the Central Banks remain massively and permanently involved in the liquidity equalisation between the Banks.

From a monetary policy perspective, the financial transactions tax in its current form is therefore to be viewed very critically, and it shows how important it is to precisely test a regulatory scheme before its introduction. This however takes a bit of time.

Exactly as we warned. More banks - particularly in the southern eurozone - borrowing from the ECB would not only increase German exposure to the crisis (ultimately, the ECB is taxpayer-backed). But it also negatively impacts the independence of ECB monetary policy since it will hamper the central bank's ability to exit its abnormal liquidity operations and therefore impact its ability to control policy.

This also gets to the heart of what we (and others) have been saying about the FTT.  Although the headline goals and figures look nice, the multitude of side effects (for financial markets, for pensions and even for central banks) mean the real impact of the FTT is far beyond what is envisaged or what can be effectively managed by the regulation.

Watch this space. This could become a big issue in Germany.

A successful ECB adjustment? Not exactly...

A very technical post, so we apologise in advance, but there is an interesting debate going on regarding the ECB’s decision to cut its deposit rate to 0%.

The move essentially means that banks will no longer receive any return (previously 0.25%) for depositing money (usually excess cash) in the ECB overnight. The hope is that banks will instead lend this money out on the interbank market or use the money to purchase new assets, as they did before the financial and eurozone crises, thereby eventually boosting the level of lending to the real economy.

The past few weeks have seen a debate over what the impact of this move would be. Last night was the first night that the new rate came into effect and, as expected, the level of deposits at the ECB fell significantly – by €483bn. However, the far more important is figuring out where the money went.

As the graph below shows, the money did not in fact make its way to the interbank market or into many new assets, but simply stayed at the ECB but under another heading, ‘current account holdings’.

'Current account holdings' refer to the main financial accounts through which banks conduct their dealings with the ECB. If they wish to access the deposit facility, funds must be transferred from the current account to this facility. Usually this is beneficial as it results in a slightly higher interest rate. However, now both accounts deliver no return.

So clearly, this money has merely been passed from one ECB account to another. That is not to say that it will not leave the ECB and that the deposit rate change will have no impact, but simply that it is yet to happen. After all this is only the first night where the new rate is in effect. That said, we are sceptical of how much impact the new lower deposit rate can actually boost lending, rather than simply boosting demand for already scarce assets (e.g. German short term debt), but we will discuss this in more detail in further posts.