ECB and the Future of QE

The European Union illustrated on a background marc

The ECB meets tomorrow.  The meeting is live in the sense that the central bank is widely expected to take fresh actions, ostensibly backed by new staff forecasts.  There are three broad areas that the ECB is expected to address.  

First, the current buying program has a soft end date as of the end of March 2017.  It is a soft deadline because ECB President Draghi has made it clear from the get-go that the purchases would continue until the central bank was confident that inflation was moving toward its target, which is near but a little below 2%.

The ECB is widely expected to extend the buying for six months.  Six months is the increment by which the buying was previously extended.  The ECB is currently buying 80 bln euros a month of debt.  There are some forecasts suggesting that the amount can be reduced by 25%, but we don’t think this is particularly likely as it would send confusing messages to investors and run the risk of exacerbating the recent rise in yields.  To would seem like tapering.

Second, the ECB will likely address the shortage of some securities.  Cutting the purchasing amount would not be an effective tool to do this.  Instead, there are two steps that would be to the point.  What we are talking about here is modifying some of the ECB’s self-imposed operational rules.  Until now the ECB limits its purchases to 33% of any individual security.  The ECB may consider raising it to say 50%.

The ECB limits its universe of acceptable sovereign bonds for its program by imposing an interest rate floor at the deposit rate, which currently sits at minus 40 bp.  There need not be a relationship between the deposit rate and the asset purchase program, but the optics do not look so good to decouple them.  However, to the extent that it is meaningful, the issue is on the portfolio level, not the individual security level.

The ECB could reinterpret the deposit floor constraint and apply it to the portfolio rather than the security.  This would free up sufficient securities that raising the limit of the share of individual securities may not matter so much.  Consider that in Germany, France, and the Netherlands, for example, interest rate out four years have yields less than the minus 40 bp deposit rate.   All these securities would be available to the ECB to buy.

The third issue that will likely be on the ECB agenda is the repo market.  This is an important part of the capital markets plumbing.  Investors may think of bonds as a fixed income investment vehicle.   For bond dealers, banks, and some other market participants, bonds are also used for collateral in other financial transactions, especially repo operations.  When the ECB buys bonds, it is reducing the available collateral.   One way to see this shortage of collateral is the pressure in the repo market, like the widening spread between the German repo rate and the interbank rate.  Admittedly, there is also some seasonal pressures ahead of year end.

The ECB and many national central banks have a securities lending program, where banks can borrow the bonds officials have bought.  However, the rules were not particularly convenient, and the facility has not been used as much as the situation may require.  Th ECB may modify, in the direction, of relaxing the rules to make them for user-friendly.

The ECB’s staff will provide updated forecasts, and for the first time, they will extend the horizon until 2019.  It is through these forecasts that the ECB may signal that its asset purchases are not unlimited.  Therein lies the rub.  Expanding a central bank’s balance sheet may have some desirable effects, but frankly, boosting inflation does not seem to a particularly potent effect.

Headline CPI bottomed almost two years ago.  In January 2015, eurozone CPI was minus 0.6%.  The preliminary November report put it at 0.6%.  The lion’s share of the modest increase is a function of non-core prices.  Specifically, the core rate bottomed in January 2015 and was retested in March and April last year.  The core rate has stood at 0.8% from August through November.  The ECB’s staff projects 1.2% annual CPI in 2017 and 1.6% for 2018.  A forecast of 1.9% for 2019, could be interpreted as signaling that QE is not indefinite.

The eurozone economy is growing near-trend.  Since March 2015, the eurozone aggregate growth has averaged almost 0.4% a quarter.   However, the eurozone expansion may be slower this year than last. year.  The year-over-year pace in 2015 was 2.0%.  In Q3 16 it was 1.7% above a year ago levels.  Given the base effect, it may be hard to match that this year.   The Bloomberg consensus expected 1.6% growth this year and 1.3% next year.  The ECB’s staff forecast in September expected 1.7% growth this year and 1.6% next year and 2018.