ECB acts as expected, now the waiting game begins

For anyone following twitter yesterday around the ECB’s announcement and press conference it would seem as if we have just had another ‘whatever it takes’ moment (when ECB President Mario Draghi promised to backstop the eurozone).

However, stepping back for a moment and it becomes clear that the ECB acted more or less as expected and some would argue has done the minimum necessary to retain its credibility and not be labelled an ‘all talk’ institution.

Sure, the package of measures looks more impressive when strung together but as we discussed in detail here and here, few if any of them address the crux of the problems in the eurozone which are depressing inflation and growth (delayed impact of internal devaluation, rebalancing of various economies, recapitalisation of banks and the breakdown of the eurozone’s cross border financial system).

All that said, there were a few more subtle and interesting takeaways from Draghi’s press conference.

Unanimous support is impressive but unlikely to apply to further easing
Draghi stressed that the support for this entire package of measures was unanimous. This is quite surprising given the previous Bundesbank opposition and does add weight to the strength of the decision. That said, just because unanimity was agreed here does not mean it can be easily translated into support for much stronger action such as asset purchases. In fact, Draghi’s hesitancy to talk about such a programme in more depth and the ECB’s willingness to push ahead with one suggests a lack of consensus on the issue. Furthermore, the outcry in Germany has already begun and will likely make central bankers think twice about stronger easing action.

Draghi insists the ECB is not “finished”, but its mighty close
Over the past year, Draghi has waxed lyrical about all the tools at his disposal and we have analysed them all in detail – see here. However, with this package of measures he has come close to emptying his toolkit – he admitted as much on the rate side saying that, for all “practical purposes”, the lower bound has been reached.

True, he has pulled out many of the smaller tools and retains the big sledge hammer of asset purchases (Quantitative Easing through buying either private assets or government bonds) but the bar to take such action remains high and gaining support for it remains a huge challenge. Pushing the deposit rate further into negative territory is also unlikely to work as banks will simply begin hoarding hard cash – this of course has some cost in terms of storage and security but it will not be more than a fraction of a percent. Finally Draghi stressed that this package could take some time to have any impact, between three and four quarters (9 – 12 months), suggesting that the ECB is now in wait and see mode as the emphasis falls on governments and the bank stress tests to help push along the economic recovery.

Impact of long term lending operations relies on cross border lending being revived
As the useful chart to the left shows (from Morgan Stanley via FT Alphaville) the amount which banks can borrow is again limited in countries which need it (the periphery) due to their already underdeveloped markets in lending to small and medium sized businesses. The technical structure for the TLTRO (pronounced Tel-tro) does allow for them to borrow more if they lend more but this will take some time. Ultimately, the target seems to be to encourage banks in the core to lend to banks and businesses in the periphery – this fits with the theory of the negative deposit rate which should encourage a search for yield. Rebuilding the cross border system in the eurozone remains a huge task.

Another potential question which arises is whether the end of sterilising purchases made under the Securities Markets Programme (SMP) will raise any legal issues or challenges in Germany and whether it will impact the judgement of OMT sterilisation.

In the end, the ECB has made its play and will likely now give it time to pan out. It will continue to provide dovish statements and may even talk up asset purchases in the future but it will urge patience in waiting to see if these measures have the desired impact.

ECB to ease policy but impact could be limited

Over on his Forbes blog Open Europe’s Raoul Ruparel provides a preview for tomorrow’s ECB meeting at which some action to ease monetary policy is expected.

In specific terms he sees the ECB taking the following action:

1. Cut the main interest rate to 0.15% (from 0.25% now).
2. Cut the deposit rate to -0.1% (from 0% now). This will be an unprecedented move.
3. Announce a new Long Term Repurchase Operation (LTRO) focused on boosting lending to small and medium sized businesses. The term of the LTRO will be between 3 and 5 years, rates will be reduced if banks provide evidence of a pick-up in lending (see below for a useful Nomura graphic on this).

It could also decide to end the sterilisation of the Securities Market Programme purchases, creating a liquidity injection of €164.5bn and loosen collateral rules further. The ECB will likely keep asset purchases (both of private assets and government debt) in reserve but will likely reiterate that such action remains possible as part of a broader dovish statement from Draghi.

Despite some of these moves being unprecedented Raoul forecasts that the impact could be limited. This is for three reasons. First, much of it has been priced in as the moves have long been expected. Second, the impacts of a negative deposit rate and targeted LTRO are far from certain. Finally because it does not address the key problem, as he notes:

As the chart below shows (courtesy of SocGen) the biggest problem facing the eurozone financial system at the moment remains the discrepancy in lending rates to businesses in different economies. The knock-on impact of this is limiting credit in countries where the economy needs it and where it is needed to help drive inflation and growth.

It’s not clear that the rate cut, negative deposit rate or the LTRO will help close this gap. Fundamentally this gap is driven by a few factors which these issues do not address:

• Banks continue to deleverage and overhaul their balance sheets. The ECB’s Asset Quality Review and the bank stress tests are in the process of trying to put banks on a surer footing but until they are all done and dusted this process will weigh on banks actions.
• Cross border lending system in the eurozone remains fractured. Banks and investors on the whole are still not willing to lend and invest heavily in the peripheral economies. This stops the excess liquidity in the stronger countries filtering in the weaker ones. While negative rates will seek to encourage such movement by pushing a search for yield it is unlikely to override concerns over risk and the desire for safe assets.
• As recent ECB bank lending surveys highlight the problem is not just on the supply side but also the demand side. The economic overhaul, reform and rebalancing on many of the eurozone economies (both in the core and periphery) is an on-going process. Not only does this itself limit demand but it highlights that lending must be to new sectors and new drivers of economic growth rather than helping to simply prop up older sectors (here I am thinking for example in Spain of lending to new services rather than to the old real estate and construction sector).

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 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.