ECB: Preparing Additional Measures

Published on November 26, 2014

European Central Bank officials have made it abundantly clear they are ready to undertake additional easing measures on top of the unconventional measures already taken this year, within the central bank’s mandate, if need be.

But there is still a degree of disagreement within the ECB on where exactly the bar to further easing lies, and what those additional measures should be, including from various ECB Governing Council members who have publically pushed back on sovereign bond purchases even after the display of unity at last month’s monthly Monetary Policy Committee meeting.

*** ECB President Mario Draghi, who has been able to push his fellow Governing Council members to a consensus on short notice in the past, has in recent comments and speeches raised expectations for imminent action. But barring a shocking collapse in the data over the next week, the ECB will not announce a program to buy sovereign bonds at its upcoming December 4 meeting. We also find it implausible, as suggested by some Street analysts, that Draghi will use the December meeting to pre-commit and “lock” the Governing Council into a sovereign bond purchase QE program for January. ***

*** But the ECB will leave the door wide open to further action – including in the very near future – if needed, after further assessment of the incoming data and the impact of the current measures. The staff has been evaluating alternative asset purchase programs for their size, effectiveness, and appropriateness within the ECB mandate, and we continue to see Q1 2015 as a “live” window for reaching consensus on additional easing measures including QE (see SGH 11/6/14, “ECB: United we Stand”), even in light of the recent objections from a number of ECB officials. ***

*** At the forefront of the private and public debate on new securities that could be purchased to expand the ECB balance sheet are, of course, sovereign bonds. But corporate bond purchases, from what we understand, are also still under active consideration, despite the fact they have drawn little mention after a brief trial balloon floated two months ago and the markets’ almost exclusive focus since then on sovereign bonds. ***

*** While not without its own challenges — lacking the double default protection of ABS or Covered Bonds and lacking the size of the sovereign market — a corporate bond program deflects some of the main objections leveled at sovereign QE. And it is seen as providing the added benefit of bypassing the banking sector and transmitting the ECB’s intended accommodation more directly and effectively into the economy. Especially if limited to higher grade bonds, it appears therefore easier to get an ECB consensus for a corporate bond program than for sovereign bonds, and we believe is highly likely to come either before a QE program, or alongside one, as a boost to the QE policy signal. ***

Forecasts are going to be revised lower yet again at the December meeting, from already anemic levels, especially on the growth side. But with expectations already so low, and the impact of easing measures taken to date yet to be seen, the main message of the meeting will be one of “wait and see,” for now, and a reiteration of the ECB’s readiness to act.

And consensus has been growing on the probability of the need for further near-term easing measures. While there is some hope that the inflation and growth numbers may have bottomed, there is genuine concern within the Governing Council that the measures taken to date may not prove sufficient in turning the all-important inflation outlook and expectations around. The period for further assessment therefore cannot be all that long.

In addition to further expansion of the balance sheet, there appears to be some consideration to going back to forward guidance on low rates to give that a firmer time commitment.

That would reinforce the rate differential story already pressuring the Euro, but there is some question as to how effective a more explicit promise could be given that market expectations are already so dovish – at this point expecting a first rate hike as far out as four years from now, or not until 2018.

Other Assets, Suggestions, and Rumors

Supranational bonds are also among the list of assets the ECB could purchase, but the timing to announce such a program would now be politically awkward. They have high credit ratings, and an announcement by the ECB of a purchase program for supranational bonds, which would include EIB and EIF bonds, would certainly dovetail nicely with the 300 billion euro fiscal investment fund stimulus plan being put together by Jean-Claude Juncker and the European Commission.

But for that very reason, there is a great deal of sensitivity within the ECB that a program to buy those bonds could be perceived as a back-door attempt at fiscal policy financing, even if that clearly would not be its intent. In addition, that market size is quite small, and spreads are already extremely compressed.

As to other securities, you can safely ignore any op-ed suggestions the ECB will buy gold or foreign securities as being widely off the mark of what the ECB actually is considering.

Assets purchases must serve some economic purpose other than a pure expansion of the balance sheet, and gold certainly does not meet that criteria. And foreign currency intervention, while certainly effective, would not exactly go over well with the Eurozone’s G20 partners, even if disguised as bonds, and is simply not on the table.

Some other options suggested in markets are less ludicrous, including interest around proposals to create a new class of synthetic or ABS bonds backed by sovereign bonds that could prove easier for the ECB to purchase under the mandate of its already announced ABS program.

But ECB officials have not seriously put consideration into repackaging sovereign bonds into new securities, and if they do purchase sovereign bonds, will likely do so on the secondary market, for monetary policy purposes, as explicitly allowed within their mandate, rather than even be seen as trying to “circumvent” their debt monetization prohibition.

Assessing the Economy

The upcoming December meeting is one of the quarterly forecast revision meetings that provide the opportunity to reassess the economy and which can often lead to policy action. But our understanding is that going into this meeting there is almost universal consensus within the ECB on the need to wait at a minimum for the results of the second TLTRO on December 11, in order to monitor the effectiveness of the existing programs and to at least give the newly launched ABS program some time to take effect.

As to the forecast itself, the ECB is already expecting inflation numbers to remain “around current” (very low) levels for a few months before gradually picking up. That will include the upcoming release of the November Eurozone CPI estimate this Friday, November 28, before the meeting. The ECB will be keenly looking at the components of the CPI as well, for any signs of weakness in the services as well as the non-services CPI.

But all that is expected to help build consensus and reinforce the need for additional easing. The hoped for year-on-year base effect pick-up in inflation expected for this quarter earlier in the year has not materialized. A good portion of that is due to a more prolonged and sharper drop in energy prices – even in Euro-denominated terms oil prices have fallen over 25% since their recent June peak – which is a boost to disposable income and consumer spending, and we expect Draghi to make that point again in December.

But with inflation expectations for the Eurozone still dangerously tilted to the downside, there is concern over what part of that energy drop is demand rather than supply related, and either way, even if largely benign or positive, could it ironically still have a negative impact on expectations given the current environment of pessimism and malaise?

And there is a good deal of sensitivity in the ECB to any further threat to price stability or tightening in real monetary conditions whatsoever.

To emphasize the ECB’s readiness to act, and push back on reports of major dissension within its ranks, Draghi elevated the promise to take further unconventional measures if needed into a formal unanimous pledge signed off on by all ECB Governing Council members in last month’s Monetary Policy Committee meeting.

He also kept expectations high for imminent action by the ECB in announcing last month that the staff was actively studying the pros and cons of various easing options. Last Friday, Draghi further fueled those expectations in stating the need for the ECB to raise inflation expectations “as soon as possible.”

But there are clear disagreements still within the Council on the effectiveness, need, or desire for sovereign bond purchases at this point, as has been openly communicated by some ECB hawks.

We believe much of that resistance can and will be overcome in relatively short order if the data convincingly reinforces the case for the need to act further, but there is nevertheless strong consensus that at minimum, the ECB should wait until the results of the TLTRO program and to give the Covered Bond and Asset Back Securities Purchase Programs at least a few weeks to filter through the system before taking further action.

We expect Draghi to also emphasize the 2012 “target” for the balance sheet is not a target per se but an “expectation,” meaning policy will not be reverse-engineered to hit a specific number.

But it is rather a case that the ECB is pushing its balance sheet in that direction in order to achieve its real target, which is to get safely back on track towards a 2% or slightly lower inflation.

Assessing the Current Easing Programs

ECB officials are very cognizant of the fact that bank demand for TLTRO loans may be an imperfect indicator of the success of its current policy track at best, Indeed, high take-up at times could be seen as a sign of stress just as banks might borrow less for good reason if markets are easy and they get cheap funding elsewhere.

Furthermore the LTRO bank lending facility is an inherently limited easing tool in that it is demand driven – the ECB cannot push money out into the system, but needs to pull banks in – and if the economy weakens more, banks could borrow even less no matter what terms the ECB puts on offer. And finally, will TLTRO funds simply be used to repay higher cost debt, or to take out new debt as intended?

The ECB will nevertheless wait to see how the second tranche pans out.

Behind the optimistic talk the ECB is also realistic in understanding the challenges both in implementing its ABS program and expanding its potential market size and impact.

The program has taken months to sign off on and has proven as, if not even more, complicated to implement than originally feared. With issues from due diligence in fragmented markets to appropriate pricing, the ECB has thus outsourced its ABS program to private consultants.

There is nevertheless a hope and expectation that ECB involvement will lead to further new issuance and growth in the size of the market. The US experience with the Residential Mortgage-Backed Security markets, which recovered after the Fed embarked on its MBS purchase program, is being seen as a model. Of course in the Fed’s case, there was reasonable underlying demand for the mortgage securities to begin with.

There has also been some frustration that national governments have failed to more aggressively guarantee mezzanine tranches and lower tier ABS credits to allow the ECB to go down that credit chain in its purchases.

But realistically there is also a question whether national guarantees would even have an unintended perverse side effect of favoring markets with higher credit government backing, northern countries that don’t need the additional stimulus, at the expense of issuers in lower rated countries.

QE the Answer?

As the ECB staff looks at alternative asset purchase programs, they are measuring not just market size for expansion of the ECB balance sheet, but the potential effectiveness and desirability of purchasing any given assets as well. And clearly there is some controversy still around the purchase of sovereign bonds on that basis alone.

One question is how much spread there is in any given market and how much more stimulus active ECB purchases can hope to achieve. Another is how much they would distort other markets and incentives.

Here, even while ECB officials need to stick by their mandates, there is unquestionable disappointment in both the pace of reforms in various member states, as well as in the prospect for any significant relief on the fiscal side. Both hawks and doves within the ECB are uncomfortable with continuing to write “free checks” to governments that are not doing their part.

The ECB nevertheless will do what it needs to do. Draghi has also been supportive of Juncker’s 300 billion euro stimulus program, (see SGH 9/26/14, “Europe: Searching for Fiscal Stimulus”). But there is a real issue around the timing of even the limited stimulus that will provide, in that an agreement is not expected to be reached until mid-2015, and the impact of any investment programs unlikely to felt until 2016.

Likewise, there is a timing issue with the recent modest softening in Germany’s tight stance on additional investment spending. Suggestions that the 10 billion euros budgeted for investment in the multi-year plan out to 2017 may be increased to 20 billion euros are only directed at spending in 2016 and beyond, and not next year’s budget. So the Eurozone will be faced with a fiscal spending gap in 2015 if the economy does not bottom as hoped, and the ECB will yet again have to bear the vast brunt of the responsibility for stimulating the Eurozone if the recovery shows no sign of taking place. And all that points back to QE.

Between various alternative methods for implementing a sovereign bond program, the ECB is leaning towards pro-rating purchases of sovereign bonds on the basis of the “ECB Key” – a blend of population and GDP weighting that is used to calculate the contributions (and thus liability) to the ECB. That is considered to be the cleanest and most objective measure for purchases on a legal and political level.

For monetary policy purposes however, purchases on a market-weighted basis would be more effective, and easier to implement. But effectively rewarding countries that have issued the most debt, at the expense of the more fiscally disciplined member states, is politically unpalatable.

Perhaps the biggest risk the ECB faces, and is increasingly coming to realize, is that too much weight is being put on this “magic bullet” of sovereign QE that may come later than when it would be most effective. With spreads already well compressed, there is a fear that the QE program may end up having less of an impact on the portfolio reallocation, inflation expectations, and currency channels than envisioned.

That is why even with December, as we expect, a wait and see meeting, we do not and have not been expecting the runway for a decision on further measures to be very long at all, namely by the first quarter of next year.

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