ECB: Easing without Cutting

Published on September 1, 2016

The European Central Bank Governing Council will be considering options for extending its asset purchase program beyond its currently scheduled March 2017 expiration date at its meeting next week:

** The QE program will most certainly be extended – whether formally announced next Thursday, which we expect, or at a later meeting this year – and that will highlight the need to address a scarcity down the road of assets eligible for purchase.

** A consensus appears to be shaping around authorizing the ECB and National Central Banks (NCBs) to buy securities yielding below the negative deposit rate – currently at -0.4% – and to potentially lift the self-imposed Collective Action Clause limit on per issue bond purchases for very highly rate securities unlikely to ever default.

** That could drive rates even lower on highly rated (and low-yielding) bonds, even without an actual cut in rates, which is not currently on the table.

** It will be politically awkward for the ECB to take losses, both on a carry basis and potentially on an eventual capital appreciation mark to market basis, on these bonds. But the ECB will make a threefold case to counter the likely criticism: this is not fiscal monetization since the sovereign bonds are bought on the secondary, not directly on the primary market, the ECB makes enough income in other areas to offset potential losses, and the goal of the central bank is not to make a short term profit anyway but to meet its inflation mandate and support the economy.

** An alternative option is to switch from an ECB Capital Key guideline to allocating sovereign purchases to a market valuation or size-based guideline. Both of these would open up more bonds for purchase, and in the process would favor peripherals and especially Italian bonds. But a switch away from the ECB Key does not appear to have much support.

** If, down the line, economic conditions were to deteriorate further and the ECB were to need to ease even more, the ECB seems hesitant to undertake another cut in the negative deposit rate. While plausible and certainly easy to implement, a push deeper into negative rates is increasingly seen across the ECB as offering mixed benefits and cost effectiveness at best.

** The ECB is not at the technical, so-called effective lower bound, but there is increasing psychological cost and resistance to ever deeper negative rates not just from German consumers and savers, but from the French now as well.

** Instead, if another significant dose of stimulus were to be needed, ECB officials appear to be leaning towards expanding asset purchases to equities, the only other real significant size pool of assets remaining. That option, however, is not on the near horizon, and seems unlikely to go to the forefront of the central bank policy options until and unless conditions do indeed warrant some means of extraordinary monetary easing.

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