ECB shows activism but falls short of true QE
Overall, we welcome that the ECB has finally acted with a broad package. We also think that unanimity on the package was a very positive development and sends a strong signal of unity.
The ECB has just published a significant proposal with many different measures to tackle the low inflation problem. The package aims to (a) ease the monetary policy stance, (b) enhance transmission to real economy, (c) reaffirm the ECB’s determination to use unconventional instruments if needed.
In our assessment, the package really aims to tackle (a) and (b) but it is not a serious attempt to change inflationary dynamics with quantitative easing. The euro/dollar rate initially depreciated by 0.7%, but it returned to the same value as before the announcement in 1 hour after the end of the press conference.
We expect that the bundle of measures have an effect on inflation, however, it is not as aggressive as it may look at first sight and further measures will likely be needed later. Four observations inform our judgement.
- This package is really about a slight easing of monetary policy and about an attempt to improve monetary policy transmission by restoring the bank lending channel. We consider both steps to have been necessary to avoid a further fall in inflation. However, the small cut in interest rates will have minor effects (see our earlier post on this here), while effectiveness of the targeted longer term refinancing operation (TLTRO) will depend on whether banks will be ready to take up the liquidity. The problem with the euro area currently is, however, not the lack of liquidity but the lack of lending to the real economy. Banks actually pay back their previous LTROs. One of the main improvements of the TLTRO over the previous LTROs is that it will carry a fixed rate, and thereby a financial incentive to lending, as rates cannot go down further but instead can increase during the next four years. The other main improvement is that TLTRO is conditioned on new lending. However, all depends on whether there will be significant demand for credit coming from the corporate sector. In many countries, debt in the corporate sector is actually quite high and the sector attempts to deleverage. So our take is that the TLTRO will help to reduce fragmentation but its effect on inflation may be less important than what one hopes for.
- The decision to suspend the sterilisation of the liquidity injected under the Securities Markets Programme (SMP) is questionable. The SMP had a particular goal: to address the malfunctioning of securities markets and to restore an appropriate monetary policy transmission mechanism, while not affecting the stance of monetary policy. With today’s decision, its aim is now changed to affect the stance of monetary policy. Such a change of a key parameter of an ECB decision undermines the reliability of other commitments of the ECB, which in turn introduces uncertainty about the parameters of other longer term ECB commitments. If the ECB wanted to inject €175 billion liquidity into euro area money markets (the current amount of SMP holdings), it would have been much preferable to announce a new asset purchase programme to this end.
- The announcement of an ABS based on real loans, not complex derivatives, is more significant. We expect this to lead to the emergence of a larger ABS market. However, the ABS market is currently very small, and the ECB intends to exclude the ABS for residential mortgage backed securities, which is by far the largest ABS market in the euro area. (see Table 18 from our paper) So in fact, if the ECB was to decide to buy, it would very quickly buy up the entire current market. Consequently, the ECB’s QE programme may be quite limited in scope. Of course, one could hope that the market will increase if the ECB start buying, but it needs to be seen if the market can develop sufficiently fast, as there are some regulatory barriers. We note that the measure is unlikely to have a significant impact on inflation in the core euro area countries. The ABS market is strong in Italy, but weak in France and Germany. But inflation rates in Germany should really increase. The effect of this measure is again going to be mostly via better credit conditions. It will not substantially operate through a portfolio re-balancing effect. In the absence of a large scale ABS purchase programme and with subdued demand for credit, the impact on the exchange rate could be quite limited.
- The element that is still missing in the package is a monetary policy measure that would substantially kick-start inflation in the core euro area countries. In our paper, we have argued for the purchases of corporate bonds and European debt in an amount to have the potential of moving the exchange rate substantially. A significant QE programme would immediately have effects on core-euro area inflation as well as periphery inflation. The current package may not do that.
Overall, we welcome that the ECB has finally acted with a broad package. We also think that unanimity on the package was a very positive development and sends a strong signal of unity. We expect the package to have a positive effect, however, it will take quite some time until inflation dynamics will come back to where they should be and further measure will likely be needed. A more aggressive QE (including €35bn purchases of ESM/EFSF/EIB bonds, corporate bonds and ABS) would have anchored inflation expectations more quickly as portfolio re-balancing and exchange rate channels would have operated immediately.
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