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#Post#: 77--------------------------------------------------
What is the ECB to Do?
By: fxvictory Date: October 2, 2014, 6:27 am
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[move]What is the ECB to Do?[/move]
The European Central Bank meets tomorrow. The focus is on the
details of the asset-backed securities and covered bond plan
that was announced last month.
There are three key issues related to this new initiative: What
instruments will be purchased, how much will be bought, and how
long will the purchase program last?
The ECB will buy the safest tranche of the asset-backed
securities. The initial proposal that it could buy riskier
tranches if guaranteed by national governments was quickly
rebuffed not only by Germany, which has been critical of the
purchase plan, but also France.
Since the crisis erupted several years ago, the ECB has reduced
the quality of the assets it will accept as collateral,
including ABS. Greek and Cypriot ABS still does not meet even
these relaxed criteria. There was a report this week that
intimated an effort to make an exception of these two countries.
However, this seems unlikely as such exceptions are not fair
and would probably not have sufficient support.
Indeed, it could have very well been an intentional leak to
toughen the resolve of German and creditor nation resistance.
Recall that the decision to cut interest rates last month and
the purchase program was not unanimous. Draghi referred to it
as a "comfortable majority". This does not sound as if Germany
was the sole dissenter.
After the low use of the new Targeted Long Term Repo Operation
facility, there was initially some thought that this would
increase the pressure on the ECB to "shock and awe" with the
"modalities" of its asset purchase program. A Reuters polls
found a consensus expectation that the ECB would buy 200 bln
euros of ABS and covered bonds over the next 12 months. In a
poll shortly after last month's ECB meeting, the consensus was
for a 300 bln euro program.
We see some risk that the ECB does not announce the size of its
purchase program. This would maximize it operational
flexibility. Once it announces the criteria of its purchases,
the market can deduce the potential size. This is true of
covered bonds as well. The prior two covered bond purchase
programs were 40-60 bln euros, which would be the lion's share
of the outstanding supply.
One significant wrinkle is that ABS and covered bonds have been
used extensively for collateral at the ECB. For example, banks
retain part of the covered bonds, but these are used as an
emergency liquidity backstop and the banks may be reluctant to
part with these. The weakness of the housing market through
much of the eurozone and the asset encumbrance rules, argue
against a surge in new supply of covered bonds.
Draghi had indicated desire to lift the ECB's balance sheet back
toward 2012 levels. We have cautioned against making a fetish
of this target. It is not clear that it is an official policy
target; more a desire, perhaps, than a commitment. Still, some
argue that this is not quantitative easing, as if quantitative
easing has an agreed upon definition. In the US, for example,
Bernanke did not call the Fed's long-term asset purchases
quantitative easing, but credit easing.
Some argue that to qualify as QE, sovereign bonds need to be
purchased. The Bank of Japan buys government bonds but also
buys REITs, ETFS, and corporate bonds. The different policy
responses in among the major economies is partly a function of
different types of capitalisms. The US and UK, for example,
rely more on markets to distribute capital, but Japan and the
euro area remain bank-centric.
Not only is the definition of QE not agreed upon, but its
purpose has varied. When long-term assets were initially
purchased, it was to alleviate financial market stress by
pushing down interest rates and displacing investors out of
risk-free assets. Its goal was later broadened to include
resisting deflationary impulses, and then used to stimulate the
real economy.
The goal of the ECB's asset purchase plan is to arrest
disinflation, re-anchor inflation expectations, and help boost
lending to small and medium businesses and households. While
Draghi, like all central bankers, are loath to limit policy
options a priori, those looking for a hint that the ECB is
considering a sovereign bond purchase scheme will likely be
disappointed. It is not just because of German (and creditor)
opposition. The ECB has overruled German objections several
times, including the initial bond purchase plan (SMP), the
Outright Monetary Transactions, and again with the recent rate
cuts and asset purchase plan.
It is not just the legal hurdles, as the market awaits the
European Court of Justice ruling on the OMT, for which the
Bundesbank's Weidmann testified against. Weidmann himself
previously indicated that under certain conditions QE might be
acceptable. There are non-political and non-legalistic reasons
to be suspicious of a sovereign-based QE. What is the point?
Eight eurozone members have negative 2-year yields, including
Ireland and Slovakia. Germany's 10-year bond yield is below
90 bp. Italian and Spanish sovereign yields are at record lows
though debt levels are at record highs.
Of the ECB's challenges, high sovereign bond yields are not
among them. It is not clear that buying sovereign bonds will
boost inflation. The weaker euro may have a greater impact on
boosting price pressures than lower nominal interest rates. The
link between sovereign rates and rates paid by households and
SMEs is not very tight.
During the Great Depression, when the US was also more
bank-centric, the Federal Reserve dis-intermediated the banks.
They moved into the breach created by banks either unwilling or
unable to lend. The Federal Reserve lent directly to small and
medium sized businesses. While the ECB does not have that
experience in its short history, some of the national central
banks have made loans to businesses.
In a larger sense, what ails the eurozone might not be amenable
to monetary policy. And the only reason that monetary policy is
being over active is that fiscal policy is frozen. The cult
of austerity means that most countries do not have scope to use
fiscal policy. Those countries that have the scope, like
Germany, do not have the will. The grand coalition government
in Germany has agreed to deliver a balanced budget next year.
The recent and sharp decline in the yen is expected to reignite
the upward pressure on prices. The decline in the euro may do
the same for the eurozone. Earlier this year, we suggested
that the ECB should consider taking a page out of the Swiss
National Bank’s play book. When it wanted to ease policy, the
SNB was constrained from a QE operation by the lack of
sufficient domestic bonds. It bought foreign bonds.
Rather than take the controversial step of buying member bonds,
the ECB could buy foreign bonds. It would not have to do a
large size. An announcement to buy a relatively small amount of
Treasuries is well within the ECB’s mandate and would have a
dramatic effect.
It would likely annoy US officials. The Treasury’s report
earlier this year urged foreign officials not to buy US
government bonds. This, they argued, prevents the adjustment
process to which the G20 are committed. A weaker euro simply
borrows (or steals, depending on your vantage point) growth from
elsewhere. It does not create the conditions for sustainable
growth, the way that structural reform can. However, if the
ECB’s foreign bond purchases were part of a larger commitment
to pro-growth policies and structural reforms, it would likely
be more palatable
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