Squaring the Circle: A QE for the ECB

The European Central Bank is in a pickle.  The pillars of monetary policy, money supply growth and inflation, are crumbling.  The main interest rate it influences, the repo rate, is already at a lowly 25 bp.  Excess liquidity is trending lower as European banks returned funds borrowed under the Long Term Repo facility.

This is contributing to  upward pressure on the EONIA, the overnight rate, and making it more volatile.   EONIA is double what it was a year ago and the amplitude of the swings, more violent.  Lending to households and businesses has been contracting for nearly two years.

The risk is that the situation gets worse.  Commodity prices have fallen.  ECB President Draghi indicated last week that the rise in the euro is slowing the economic recovery and increasing the risk of deflation.

ECB officials play up the options at their disposal, but a closer examination suggests this simply is not so.  There are no easy and effective courses of  action.    Those that are easy, like shaving the repo rate, are not very effective.    Those that could be effective, like quantitative easing, are not very easy given the ECB’s charter.

The ECB has said for several months that it is technically prepared for a negative deposit rate.
  While no doubt this is true, such a move is unprecedented among large countries.  It could reignite the financial crisis by squeezing banks and money market funds, which provide wholesale funding.

The Outright Market Transaction scheme offered by Draghi in the middle of 2012 has not been operationalized and, with Spain and Italian rates at multi-year, if not record, lows, there is little incentive for the most likely candidates.  Moreover, the Bundesbank’s doubts about the legality of OMT, expressed before referring the case to the European Court of Justice, shrouds the program, even if the ECB formally denies it.  Trying to invoke the OMT now could trigger an institutional crisis if the BBK refused to participate.

The ECB has indicated it is interested in reviving the asset-backed securities market as a vehicle to boost lending to households and small and medium businesses. 
   The ECB could buy those bank bonds backed by such lending.  However, there is much preparation and regulatory changes that need to be enacted to turn this into a reality.  This means it will not be available anytime soon.

Perhaps the ECB can learn something from the Swiss National Bank.  Recall that when confronting deflation a few years ago, the SNB’s ability to implement quantitative easing was limited by the fact that its domestic bond market is too small.  Forced by circumstances, the SNB opted to buy foreign bonds.

In the early days of the Abe government in Japan, some advisers were suggesting purchasing foreign bonds.   It subsequently moved away from this and stuck to buying domestic bonds and risk assets, including ETFs and REITS.

The IMF and others have advocated that the ECB adopt QE policies.  However, this would contravene its legal framework.  However, the Swiss experience and the Japanese consideration suggests it should consider buying foreign bonds.

There was some objection over Japan’s notion of foreign bond purchases as part of QE because it would appear to be too similar to intervention.    The ECB has repeatedly said that it does not target the exchange rate so a foreign bond buying program would seem to confuse that message.

This underscores the importance of the ECB explaining its effort as an attempt to fix the transmission mechanism that is preventing the highly accommodative monetary policy from translating into lending and offsetting deflationary forces.  That is the goal.  The buying of foreign bonds would indeed entail the sales of euros.  While it may produce a welcome side effect, it is not a direct goal.

There may be some institutional challenges.  For example, there appears to have been two episodes in which the ECB had intervened in the foreign exchange market.  The first was shortly after the euro’s advent as it trended lower, reaching $0.8230 in October 2000.  The intervention was a coordinated operation and the US also participated.

The ECB also reportedly participated in the intervention against the yen after the earthquake, tsunami and nuclear disaster in Japan.
  A couple issues are not immediately clear.  Was the intervention conducted at the ECB’s initiative, or was it a political decision the ECB carried out?  Did the ECB use its own resources to when it sold the or was it provided the funds?

The right of the ECB to intervene in the foreign exchange market in order to more effectively implement monetary policy, given the arguably broken transmission mechanism, does not appear to contravene its legal structure.   Such intervention, especially if not sterilized (offset via money market operations) would boost the ECB’s balance sheet.  It would likely increase the money supply and boost liquidity.  To the extent that it would weaken the euro, it could help reduce the risks of deflation.  It may also help the periphery boost competitiveness and growth.

The media would cry “currency war”, but if the main trading partners of EMU, like the UK, US and Japan said it wasn’t, and there was no retaliation, the fears would fade.  

The ECB does not have any good choices.  It is restricted by its mandate and the legal challenges to OMT.  The measures that the ECB can do like the cut repo rate, reduce the lending rate, and stop sterilizing bonds purchased under the SMP program are insufficient to address the ECB challenges.  The strength of the euro compounds its difficulties.

A quantitative easing that has been advocated by a number of observers, including a German think tank and the IMF, is difficult to implement the way the Bank of England, the Bank of  Japan and the Federal Reserve did.  While not constrained by size of the local bond market, the way the Swiss National Bank was, the ECB is constrained in a different way.  Buying foreign bonds appears to be a way to square the circle.

The importance of this to investors with euro exposure is that few have yet to discuss this possible course publicly, though our impression is that European officials are more concerned about the financial and real economy trajectory that perhaps the recent ECB meeting suggested.  Subsequently, the preliminary February inflation estimate was revised lower, and the euro has appreciated by more than 1% on a trade-weighted basis since the March meeting.  Draghi’s speech in Vienna last week, already gave investors notice that the saliency of the euro in the policy making equation had increased.

This piece is cross-posted from Marc to Market with permission.