What is at stake?
The monetary situation in the Euro area is still rather fragile and the main indicator (medium-term market implied inflation expectations) points to the direction where additional monetary easing is definitely required. When the ECB governing council assembles tomorrow and on Thursday to decide on the rates and on the monetary policy stance in general, the members of the council will face a thorny choice between various self-conflicting options.
First of all, it should be noted that making policy decisions is very delicate in the current situation, given all the political and legal constraints inherent in the Euro area constellation. However, if we focus on the main objective, i.e. keeping inflation expectations firmly anchored (close to 2 per cent, in the medium term), the data is rather disappointing. The market implied expectation for the 5 y inflation in the medium term has drifted downwards for some time now. The current number is well below 1,3 %. The figure below illustrates this very clearly. This number is surely one of the main market indicators that the ECB watches keenly.
Fig. 1. 5y5 Inflation swap forward -implied inflation
Despite of the current extended asset purchase programme (QE), it seems that the monetary policy channel is still somewhat impaired, as significant expansion of the Eurosystem consolidated balance sheet has not lead to a substantial increase in bank lending in the Euro area. This impairment ultimately affects inflation negatively, at least if we assume that inflation depends somehow positively on the money in circulation (cash and bank deposits).Remember, MV=PY.
Fig. 2. Eurosystem balance sheet (ECB +national central banks)
Again, we must remember that QE does not automatically increase the amount of “real” money, because the stock of bank deposits (firms’ and peoples’ money) does not automatically change due to QE. QE does however increase excess reserves by crediting commercial banks’ central bank checking accounts, and flattens the yield curve.This should encourage lending and borrowing. There is also the FX/currency channel, which boosts exports, to some extent.
Fig. 3. Euro area money supply (M3) -annual growth rate, SA
One might say that in the Euro area we have an impaired bank lending channel, as new bank lending is still rather sluggish. For me this seems to be effectively a demand side problem and should be tackled with fiscal measures. However, given that we do not live in a sovereign money and/or fiscal union, the ECB must act, and it should act sooner than later.
So, what are the main options and obstacles? As the eurosystem is buying a large amount of government bonds each month (almost 80 bn eur a month), the price level of bonds has increased to the extent that a large portion of sovereign bonds in Euro area have negative yields. This does not need to be a problem, as long as the instruments yield on average more than -0,4% (central bank deposit rate). This will guarantee a positive net interest income for the national central banks.
So, as long as the net interest income is positive (on average), negative yields are not of any major concern for the Eurosystem as a whole. For banks, the ultra-low interest rate environment is toxic, as most of the loan books are tied to euribors, and the deposit rates are not. So the price of lowering the central bank deposit rate is basically to worsen bank profitability (and to punish savers in general). Given the low levels of capital in some parts of the banking system, low profitability might be a problem in terms of financial stability. However, it might be so that a 10-25 bps further cut in the deposit rate is realistic, given that the other options are even more difficult.
It might be nevertheless argued, that the negative rate does not really boost lending, because we might have reached the limits of the effect of interest rates on investment decisions and banks will charge positive rates from loan customers anyway.
Given that the low yields are a de facto constraint, what else could be done in order to expand the QE programme? Well, one can always target longer maturities, whenever possible. Also, one can target more credit risk. This is technically easy, but politically hard. Technically speaking, if one would like to expand the QE programme, to say 100 bn a month, which I think is needed, one could easily do so by buying solely for example Italian government bonds. However, this would mean deviating from the capital key pro rata -approach and thus would be a (larger) step towards a fiscal union, at least that’s how it would look like in many countries. Politically not likely.
The final and the most radical option would be to launch an all-out equities and/or junk bond purchasing programme. The eurosystem could start buying very risky assets with high yield. I think this is off the table, as is helicopter money, at least for now.
To sum up on the options
- Lower the deposit rate by for example 25 bps to -0,65 % (and the repo rate and the rate on marginal lending facility accordingly, in order to keep the interest rate corridor tight). This would lower the market rates further across the yield curve.
- Relax the issue limit and/or capital key. This would mean that the Eurosystem could acquire a bond issue in its entirety and target individual Member States. Politically delicate, not likely.
- Extend the QE programme to equities and/or junk bonds as the BoJ has done. This would most likely be rather controversial and would inflate the equity market further still.
Given the legal and political challenges, my bet would be that there will be a further cut in the interest corridor. This might be accompanied with some bond buying below the -0,4 % limit, as long as the overall profitability of the Eurosystem is positive. Alleviating from the capital key creates more political strain and tension, compared to the benefits of QE.
Has monetary policy reached its limits?
Nevertheless, I think that in the Euro area, monetary policy has reached its limits, more or less. Bank profitability and capital issues constrain further rate cuts and alleviating from the capital key could be politically toxic. So what is left is little. Structural reforms are necessary, but in this case, we need most likely more support from the fiscal side. Given the pathological current account surplus of Germany, it seems clear that the external value of the Euro is too weak for Germany. The accumalating huge net international investment position due to persistent current account surpluses should be tackled by the European commission and the Council, using the six-pack provisions. The other options for fiscal stimulus are basically left with some boosted form of the Juncker plan, and/or boosting the EIB lending volume. One could envisage a role for the ESM as well, at least in theory.