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The ECB and Sisyphus: it won’t be finished unless it does QE

9th June, 2014

Mario Draghi, 5th June: “Are we finished? The answer is no… within our mandate, we’re not finished yet.”

After the announcements made following the ECB’s June meeting, we hope this wasn’t an idle remark from the President because the ECB will almost certainly have to come back and do more to exorcise the risk of deflation in Europe. He and his colleagues certainly went an extra mile to try and stimulate bank lending in the Eurozone, but this is neither here nor there. Yes, it is important to regulate and repair the banking system, and to ensure that they are able to play a role in supporting sustainable economic recovery. But alone, the ECB’s lending policy strategies are akin to repeating the task of Sisyphus. Nothing short of QE will fulfill the ECB’s role of supporting an economic recovery that it is largely the job of governments and the Commission to deliver.

Why then the mostly positive and congratulatory response to the ECB’s latest monetary policy initiatives? Most commentators and analysts welcomed the ECB’s measures as going beyond expectations, and maintained that the ECB deserved still to be taken seriously with regard to ‘whatever it takes’. We can hope these people are right but the ECB still hasn’t deployed the instruments that the Eurozone economy requires, and lacks the political room for manoeuvre, which is open to its peers. Its cheerleaders overstate its capacity to restore economic functionality to the Euro system but it hasn’t yet acknowledged why the risk of deflation haunts the Eurozone, and what the ECB can and should do about it, and what it can’t, i.e. the function that QE can play, and what the fiscal and governance responsibilities of European governments and Eurozone institutions, including the Commission, are, and where they are falling short…

Admittedly, the Bank of Japan exists in a different political context but let’s just recall what happened after the newly elected Japanese Prime Minister put his own people in charge of the Bank of Japan in 2013. The central bank pledged to double the size of its balance sheet as a share of GDP, and committed itself to a 2% inflation objective within two years. It made no bones about what it was seeking to do. It said it would try to overcome deflation by stimulating aggregate demand a) to reduce the output gap and b) so that the government would be better able to pursue supply-side, structural reforms designed to boost Japan’s potential growth rate.

By June 2014, the Bank of Japan seems to be sounding a little too triumphalist for my liking, and it is by no means clear that the difficult bits of Abenomics will succeed in re-energising Japan’s potential growth and competitive capacity, or lifting the employment of women, wage and salary formation, and immigration. But there’s no question that the Bank of Japan has put its policy cards on the table, insisting what it thinks it can do and on an open-ended basis, and what it can’t.

For my part, I acknowledge the ECB has gone even further this time than when it introduced OMT’s. Nevertheless, the most telling thing Draghi said to reporters in Frankfurt after his announcements was that while the package of measures was significant, the ECB may not be finished yet. This is hopeful, but we’ll see.


Deflation acid test

Judgement of the ECB should really now only focus on overcoming deflation, given that it has already done much to provide liquidity to the banking system and alleviate credit supply constraints, and that it is now, as Single Supervisor, overseeing an Asset Quality Review and forthcoming stress test to assess the capital needs of major banks.

Combatting deflation should pre-empt the point at which the Bank of Japan finally arrived last year. One of the immediate boxes the ECB could, and should, check is the Euro, i.e. whether financial markets are sufficiently persuaded of the ECB’s policies to drive the currency significantly lower, below 1.30 in the short-term, and perhaps down to 1.20 against the US dollar or lower. It is possible that negative deposit rates and low yields will encourage the Bank for International Settlements, and other official institutions that hold Euro reserves, to switch some assets out of the currency, but this isn’t going to be a game-changer. The ECB hasn’t done enough to weaken the Euro, which will sit rigidly in its current or recent trading range, supported by the Eurozone’s external surplus.

What the Euro Area really needs is a strategy, worked out with member governments, to lessen deflationary pressures in the periphery of Europe, while pushing up inflation in Germany. If this were ever to happen, then a rise in Bund yields relative to the rest of the Euro Area, would one day constitute credible evidence not only that deflationary pressures were being overcome, but also that Germany was shouldering a part of the adjustment in Europe. No one should be optimistic that this is even close to happening, or ever will – until such time, if ever, as German economic and governance policies with respect to Europe change in a material and shocking (compared to now) way. For that to happen, one would imagine the Euro Area would have to have re-entered a financial, and existential crisis, or a political crisis in which a major European country was threatening to quit the Euro.

As to the immediate future, with Euro Area inflation at 0.5% in May – far away from the ECB’s about 2% target – many Euro Area countries are labouring with inflation rates of 0.5% or less (some with negative rates). Protracted low inflation, let alone deflation, alongside a feeble economic recovery, negates hopes for stronger income formation, undermines hard won competitiveness gains, and raises the risks of debt stability. As it is, the ratio of debt to GDP will, according to IMF forecasts, continue to rise through 2016 at least – and that is on the basis of economic and nominal GDP forecasts that are liable to go off the rails.

The ECB has gained a reputation over the years for promising much and then underwhelming on delivery. At the June meeting, the ECB certainly tried harder, but what is announced isn’t really going to have a dramatic effect, as we explain in the next section, and doesn’t recognise the proximity and danger of deflation. That would indeed be a good and bold first step.


Critique of ECB’s measures

Interest rate measures

There’s no question the ECB has boldly gone where no other central bank has gone before by cutting the rate it pays banks on deposits from zero to -0.10%, along with a comparable reduction in the refinancing rate to 0.15%, and a 0.35% fall in the marginal lending facility rate to 0.4%.

Negative deposit rates certainly represent a novel twist, but in all the commentary that surrounded expectations before the ECB meeting, no one seriously thought that such an interest rate initiative would seriously spur banks into making new loans. In any event, banks’ deposits at the ECB have fallen sharply since last year, along with their excess reserve holdings, to which negative rates also now apply. So the incentive for a change in banks’ behaviour is even smaller.


Liquidity and lending measures

1. The ECB acted to boost short-term liquidity by extending the provision of its 3 month loans (MROs) at full allotment until the end of 2016 (rather than terminating them in the middle of next year). It also announced it was ending the sterilisation of the purchase of sovereign bonds made under the Securities Markets Programme, which started in early 2010 until it was terminated in September 2012. Its SMP holdings are roughly €165 billion, and so the cessation of weekly bill issuance will gradually boost liquidity by this amount, though the effects will, of course, dissipate over time.

2. The announcement of targeted long-term repurchase operations (TLTROs) got more attention. TLTROs will effectively give banks cheap funding until 2018, provided they use it to make loans to the non-financial private sector, but not to households for the purpose of mortgage borrowing. Rates will be fixed at the refinancing rate plus 0.1% at the time of allotment, and the volume could be as large as €400 billion, or the equivalent of nearly 5% of Eurozone GDP, or 9% of outstanding loans to non-financial corporations.

There is no certainty or guarantee, however, that the full allotment will be taken up, and the extent to which the TLTROs are used might actually be quite limited. It will depend partly on whether banks need and want cheap funding to make loans to companies and to SMEs (they can’t repay TLTROs for two years), and partly, of course, on whether there is strong demand on the part of companies for new credit from their banks.

As things stand today, banks do not seem overly constrained in making loans, notwithstanding regulatory change, and the coming Asset Quality Review and stress test. The April ECB Lending Survey (quarterly), covering the period 24th March to 8th April, noted that credit conditions had stabilised in the Eurozone, that net tightening of credit standards by banks had fallen to well below historical averages (going back to 2003), and that banks mostly continued to report improvements in their net retail and wholesale funding, and fewer constraints from sovereign debt holdings on their balance sheets.

The bigger problem is loan demand. In the latest (April) money supply report, loans to non-financial corporations were still 2.7% lower than a year ago. Loans to private sector entities, including households, were no higher in April than in early 2008, and have been lifeless for almost 3 years. Interestingly the only component of private sector loan demand that has shown some resilience, growing with not a little gusto over the last 6 months, has been mortgage loan demand – specifically excluded from TLTROs. Other consumer loans and non-financial corporate loans have continued to decline on both a 3 month and 12 month rate of change basis through April.

3. The other major initiative that caught attention was the announcement that the ECB was working on a proposal, potentially, to buy asset-backed securities. We don’t know how far away this is, and indeed, even though there has been quite a lot of asset-backed issuance going on this year, the size of the market is small. The total market size in the Euro Area is a little less than about €1.0 trillion, but of this, €650 billion comprise residential mortgage-backed securities. Of the remainder (consumer and corporate loans), roughly half may be pledged as collateral, and therefore ineligible for an ABS purchase programme. The ECB needs to encourage the market to develop and deepen.