The European Central Bank’s decision on November 7 to cut its refi lending rate to 25 basis points was taken with full expectations the quarterly inflation forecasts at this Thursday’s meeting will show new downward revisions.
Senior ECB officials have in fact gone to great lengths since then to speak in one voice on both the dangers of the prolonged weak inflation readings that dropped especially sharply in October, and a willingness to take additional measures if market rates creep up or their inflation mandate comes under renewed and continued sustained downward pressure again (see SGH 11/5/13, “ECB: Back in Play,” and 11/7/13, “ECB Follow-up: A United Front”).
*** That said, however, any further limited refi rate cuts will most likely require a further deterioration in the inflation outlook than the 0.2% or so downward revision to the inflation forecast for 2014, from 1.3% to 1.1% or 1.2% as well as the expected first roll-out of a 2015 forecast in the 1.3% to 1.5% range. ***
*** Instead, it is our sense that serious consideration is being given to boosting liquidity in the system, either through a renewed 12-18 month LTRO or through easing the weekly sterilization of around 180 billion Euros in SMP program bonds purchased by the ECB held in inventory. The 12-18 month LTRO could come over the next three meetings, even possibly flagged as early as at this Thursday’s meeting, which would certainly be a positive surprise to markets. Our understanding is that this liquidity add could come to offset the dwindling three year LTROs rolling off at the end of 2014 and beginning of 2015, rather than being kept in reserve as markets expect for the upcoming Asset Quality Review in case of systemic liquidity strains. ***
*** On the non-conventional side, we believe going forward a cut in the deposit rate to below zero is unlikely. While the ECB will continue to stress it is technically ready to cut deposit rates below zero if necessary, it is still seen as a response in a crisis situation and an option that could come with unintended “negative” consequences and in fact could be limited in scope as well. ***
*** Perhaps more intriguingly, while we believe it remains a remote possibility, there has been surprisingly little pushback to at least the principle of bond purchases as an alternative non-conventional, emergency measure. That could come in two forms; purchases of private sector assets or purchases of government bonds, with the latter still being fairly controversial. We do suspect a more vocal resistance to bond purchases would be sounded if the ECB were to actually get closer to such a decision. ***
Liquidity Adds and Twists
The ECB has a great degree of comfort and confidence in the effectiveness of liquidity operations like the previous LTROs in managing rates and pushing liquidity into markets. As Eurozone banks have been recovering and returning liquidity to the ECB, the only obstacle to another operation has been whether there is any need or demand for one.
Another liquidity operation has therefore generally been discussed and seen in context of either a response to tighter money market conditions, or as a response to potential systemic stress resulting from the ECB’s upcoming Asset Quality Reviews (AQR).
But our understanding is that a more limited term liquidity operation, in other words shorter than the previous three-year LTROs, could be under consideration to stem or reverse the already declining liquidity in the system even if banks are not clamoring for more money. As an enticement, that could come enhanced in the form of a fixed LTRO at the current rate with the optionality to reset if rates drop lower, or a variable that is capped on the upside (see SGH 9/27/13, “ECB: Reinforcing Forward Rate Guidance”).
In addition, or as an alternative, there has been active consideration of ECB adding liquidity by refraining from the weekly sterilization of bonds held in its portfolio from its now discontinued SMP intervention program.
That injection could be conducted either on a partial basis, or for the full 180 billion Euros of bonds in its portfolio. Were the ECB to stop sterilizing the full amount, the liquidity in the system would be boosted from the current 190 billion Euros (it was around 150, until the ECB just warned it would disallow repayment of funds over the turn of the year) to approximately 350-370 billion. Banks could still continue returning the liquidity after that, but at least it would be from a higher base level.
One final option under consideration is a cut in Eurozone banks’ reserve requirements. This has the advantage of at least in theory feeding more directly into the Eurozone’s moribund lending chain. It is, however, somewhat limited by size. There are approximately 100 billion Euros in bank reserves in the Eurozone system, so a cut in reserve requirements by even as much as 50% – it is very unlikely to be cut to zero – would only free up 50 billion Euros or so.
Negative Rates – Not Anytime Soon
As mentioned before, another cut in the already low, 25 basis points, refi rates would require further deterioration in the ECB’s outlook from what will already be a downwardly revised forecast. A more sanguine 2015 inflation forecast revision to 1.5% or, though highly unlikely, even higher, would be interpreted as hawkish by markets, and seen as pushback from the ECB on the need for further action.
We expect the ECB staff forecasts however to be close to market expectations. The ECB’s base case after all is still for a gradual stabilization and recovery in the all-important inflation data, albeit at new, uncomfortably low levels.
In case of a second, and more severe, leg to the downturn, the possibility of cutting deposit rates below the current zero level and into negative territory has perhaps captured the market’s imagination and generated the greatest amount of ink. We nevertheless believe the bar to a cut into negative rates remains very high, and that it remains a highly unlikely option.
ECB officials have studied and discussed negative deposit rates for months, and to a man agree that it is technically feasible. But most of the key and swing members, of the Governing Council remain extremely cautious about embarking on such emergency measures – unless, of course, faced with an extreme emergency outlook.
Top among those concerns about potential unintended or negative consequences is the impact negative rates would have on banks, and whether they would have the perverse effect of pushing banks to even more conservative and contractionary lending practices rather than forcing reserves and savings to be lent out into the system.
Related to that is the potential negative signaling effect such a move could have on confidence, as well as its impact of course on the Eurozone’s savers – most acutely expressed in Germany. It is also seen as an effective transfer of wealth from the deposit-rich banks of the North to the South, which some would argue would be a good thing, but would nevertheless be enormously politically contentious.
Perhaps as important, and less apparent to markets, is the concern that negative deposit rates may end up a tool that is not just controversial, but also comes with serious operational restraining limits.
Specifically, there are concerns that in practical terms the ECB would not be able to cut deeper than around -0.25%, as a larger cut than that would create the economic incentive to hoard cash through stored banknotes at 0% cost (once its physical costs are covered), rather than earn negative interest in a deposit account.
For those interested, some of these arguments have been laid out as well in a blog posting by former ECB Director-General for Money Markets Francesco Papadia, drawing as well on the limited experiences with negative rates in Sweden and Denmark.
Additionally, and perhaps worst of all, the empirical evidence suggests that while negative rates did help to somewhat weaken those countries’ currencies, they also did impinge on the functioning of their money markets, and in fact had negligible impact on pushing more bank lending into the system.
QE: The Dog That Didn’t Bark
Perhaps most intriguing of all is the public discussion among some ECB members about whether to purchase bonds as a non-conventional, emergency policy option.
This falls under two broad categories. One, less controversial, is the purchase of private sector assets, including bank bonds. The other is large scale purchases in the much deeper Eurozone sovereign bond market, akin to the Federal Reserve’s LSAP (QE) program, in order explicitly to drive rates lower.
European officials are quick to point out the huge differences between the US and European markets. And for the ECB, the wholesale QE type purchase of sovereign bonds would clearly be a last “in case of fire, break glass,” option, and any actual push for this – without the limits or conditionality so carefully set out in the OMT program – would almost certainly open an enormous Pandora’s Box of a fight over the ECB’s mandate, national liabilities, and limits to debt monetization under the EU Treaty.
But for now, the lack of a serious assault on this idea from a fundamental perspective is the proverbial “dog that hasn’t barked” in the arsenal. Articles 21 of the ECB Statute and 123 of the TFEU expressly forbid the direct purchase of public debt (and bailing out of sovereign governments) by the ECB. The battle would be over purchases in the secondary market, and whether such purchases are sterilized or not. But that is not a story for now.