Writing about ECB QE again.
In a nutshell, market expectations seem to be for Mario Draghi to announce €500bn of sovereign debt purchases on Thursday. There is a bit of back and forth about how those purchases would be undertaken (whether by ECB or NCB – risk sharing or risk bearing).
I think there is something missing from this debate – is sovereign QE the right medicine for the euro area?
The illness is low/negative inflation.
QE, as implemented in the United States particularly is meant to address this illness through what Ben Bernanke speaking in Jackson Hole in 2010 called the ‘portfolio balance channel’. The theory, very basically, is that as the Federal Reserve buys the safest asset classes, it forces down the yields for all asset classes as market participants buy riskier assets in order to maintain returns.
This low-yield environment reflects the Feds monetary policy stance at ZIRP and means that the central bank has been successful in implementing its policy. The inflation comes as the low yields in the market lead to more lending which leads to more growth which leads to inflation. (NB, this is monetary policy on a postage stamp, so please excuse the very broad brush).
The argument for QE in the UK was along similar lines.
For the euro area, the same logic does not really stack up.
The primary problem is that the euro area does not have a single capital market like the US and UK do. Will the ECB buying a bund lead by any route to an investor buying equity in a Portuguese bank? It is very hard to make the argument that it will.
Very much more importantly, the portfolio effect in the euro area does not seem to be a portfolio ‘trickle down’ effect at all. Instead, as this very important (imho) Alphaville post shows, it is a ‘trickle out’ effect. Investors, rather than increase their exposure to euro risk to get higher yields seem to be increasing their exposure to foreign currency debt.
At first blush, this might seem ideal for the ECB. Investment flows out of the euro mean that further ECB buying would lead to further euro weakness, meaning more imported inflation. Which seems like a great way of getting inflation higher quickly. It is practically an fx intervention from the ECB.
Unfortunately, short term success on inflation in this manner would not lead to much long term success. Fx interventions, as the SNB recently has shown, rely on flow. Once the intervention stops, the effect of the intervention quickly reverses. So, the ECB would be forced to engage in QE ∞. Which, even for the most dovish of ECB doves is not an option.
If ECB sovereign QE is doomed to fail, should it even bother trying? Or should it be a little more imaginative and try something a little different?
The ECB does have two other purchase programmes currently underway. There is the CBPP3 busy buying covered bonds (purchases since October 24th last total over €30bn) and the ABSPP attempting to buy asset backed securities (it has only purchases €2.2bn since launching on Nov 21 last with the low total due, by all accounts, to ECB bureaucratic cold feet).
If we accept the logic that QE should lead to increased investment due to low rates, then the ABSPP is good idea terribly implemented. There is a lot more that can be done.
Euro denominated corporate bonds are a no-brainer. In fact they are such a no-brainer, I expect them to form a large part of any QE announcement on Thursday.
The ECB’s own collateral list has €1.4 trillion of eligible corporate bonds that would be available for purchase. A meaningful purchase programme for these would be a big step in the right direction.
But there is one more thing the ECB could buy.
It could buy euro denominated equities.
(Don’t get too excited now, this is super-highly unlikely).
There is nothing stopping the ECB buying equities – article 18 of its own rule book states that the ECB may:
18.1. In order to achieve the objectives of the ESCB and to carry out its tasks, the ECB and the
national central banks may:
— operate in the financial markets by buying and selling outright (spot and forward) or under repurchase agreement and by lending or borrowing claims and marketable instruments, whether in euro or other currencies, as well as precious metals;
Basically if the ECB has a monetary policy excuse, it can pretty much buy anything with a market price.
The ECB has never ruled out buying equites – in fact in these quotes from the December press conference, Draghi only ruled out buying gold (and seemed to rule in buying equities)
“Draghi: On what sort of assets should be included in QE, my sense and recollection is that we discussed all assets, but gold.”
And, in response to another question:
“Draghi: I must confess I'm not entirely clear on what sort of changes they are asking from our side. We've discussed, amply, monetary policy measures and today we have discussed the possibility of doing QE where the central bank would buy government bonds as one option, but also other types of bonds and other types of assets.”
Yes, the risk management on this would be a pain. But that should not be the ECBs primary concern. The ECB's primary concern should be to get inflation expectations higher through increasing investment and growth expectations.
If, as it seems sovereign QE is an fx play, then the ECB should short-cut Bernanke’s portfolio effect and load up on the riskiest stuff itself.
It has the advantage of not falling foul of monetary financing rules, is completely legal under the treaty and would probably work very well.
Shame the chances of it happening are so vanishingly small..