ECB Holds Fire For Now, But QE May Be On The Way

BMI View: The European Central Bank continues to toe a cautious line and left its policy instruments unchanged at the April 3 monetary policy meeting. However, a noticeably more dovish tone from ECB President Mario Draghi and indications that some form of quantitative easing is a possibility, suggest that the central bank is paving the way for fresh monetary stimulus. Although Draghi is still downplaying the need to go down the road of QE, a slew of weak inflation prints and the possibility of a looming crunch in bank funding markets could ultimately force the ECBs hand.

After the European Central Bank disappointed the growing legion of voices calling for further policy rate cuts in March, the decision to hold fire again at the April 3 monetary policy meeting was not particularly surprising. However, in the follow-up press conference, ECB President Mario Draghi indicated a clear change in tone within the Governing Council and hinted that more radical measures were being discussed, including some form of quantitative easing. We have been arguing for a while now that in light of passive monetary tightening (as a result of banks repaying LTRO funds), a strong euro and still broken credit transmission channel, the ECB would need to up the ante and deliver a sizeable monetary stimulus to the beleaguered eurozone. We have also suggested that the Asset Quality Review would likely limit the take-up of another big LTRO round because of the potential stigma of acquiring funds from the ECB at a time when bank balance sheets are being scrutinised. As such, we have expected some combination of policy rate cuts, forward guidance and small-scale LTROs.

The prospect of the ECB indulging in some form of quantitative easing is by far and away the most important policy development since the Outright Monetary Transactions facility was announced back in September 2012. Early on in the eurozone sovereign debt crisis, we argued that a key pillar of any credible and sustainable crisis resolution policy would be discretionary monetary intervention in the sovereign bond markets of the sort pursued in the US and UK. The OMT announcement proved particularly powerful in stabilising the bond markets and effectively kicked QE into the long grass. Despite the success of the OMT, we have warned that the strict conditions attached to any ECB purchases of sovereign debt, coupled with uncertainties about how such a policy would be implemented (for example, would the central bank risk destabilising markets by withdrawing support if the target member state failed to meet its fiscal and economic reform targets?), could ultimately render the pledge ineffectual. With that in mind, and given that the broken credit transmission channel means that successive LTROs would run into diminishing returns to economic growth, quantitative easing would offer the best chance of delivering a meaningful stimulus to the eurozone.

Policy Rates Unchanged At April Meeting
Eurozone - ECB Policy Rates, %

ECB Holds Fire For Now, But QE May Be On The Way

BMI View: The European Central Bank continues to toe a cautious line and left its policy instruments unchanged at the April 3 monetary policy meeting. However, a noticeably more dovish tone from ECB President Mario Draghi and indications that some form of quantitative easing is a possibility, suggest that the central bank is paving the way for fresh monetary stimulus. Although Draghi is still downplaying the need to go down the road of QE, a slew of weak inflation prints and the possibility of a looming crunch in bank funding markets could ultimately force the ECBs hand.

After the European Central Bank disappointed the growing legion of voices calling for further policy rate cuts in March, the decision to hold fire again at the April 3 monetary policy meeting was not particularly surprising. However, in the follow-up press conference, ECB President Mario Draghi indicated a clear change in tone within the Governing Council and hinted that more radical measures were being discussed, including some form of quantitative easing. We have been arguing for a while now that in light of passive monetary tightening (as a result of banks repaying LTRO funds), a strong euro and still broken credit transmission channel, the ECB would need to up the ante and deliver a sizeable monetary stimulus to the beleaguered eurozone. We have also suggested that the Asset Quality Review would likely limit the take-up of another big LTRO round because of the potential stigma of acquiring funds from the ECB at a time when bank balance sheets are being scrutinised. As such, we have expected some combination of policy rate cuts, forward guidance and small-scale LTROs.

The prospect of the ECB indulging in some form of quantitative easing is by far and away the most important policy development since the Outright Monetary Transactions facility was announced back in September 2012. Early on in the eurozone sovereign debt crisis, we argued that a key pillar of any credible and sustainable crisis resolution policy would be discretionary monetary intervention in the sovereign bond markets of the sort pursued in the US and UK. The OMT announcement proved particularly powerful in stabilising the bond markets and effectively kicked QE into the long grass. Despite the success of the OMT, we have warned that the strict conditions attached to any ECB purchases of sovereign debt, coupled with uncertainties about how such a policy would be implemented (for example, would the central bank risk destabilising markets by withdrawing support if the target member state failed to meet its fiscal and economic reform targets?), could ultimately render the pledge ineffectual. With that in mind, and given that the broken credit transmission channel means that successive LTROs would run into diminishing returns to economic growth, quantitative easing would offer the best chance of delivering a meaningful stimulus to the eurozone.

Policy Rates Unchanged At April Meeting
Eurozone - ECB Policy Rates, %

However, at this stage we should not overplay either the likelihood or impact of a full blown quantitative easing programme. Although Draghi has indicated that quantitative easing could be pursued without necessarily violating the ECBs mandate, by downplaying the risk of deflation and sticking with the Governing Council's assessment of medium-term inflation expectations the prospect of near-term QE seems unlikely. Even if QE were deployed in the near term, there are several uncertainties. For one, would the ECB target the corporate or sovereign bond market? In terms of placating the Bundesbank and its predictable admonition of QE, the ECB could start by purchasing corporate bonds. However, there is a limited supply of high quality corporate debt, so the impact on the broader economy could be fairly limited. Buying sovereign debt is no more clear cut. We assume that it would be difficult to target individual sovereign issuers as this would violate the notion of the ECB providing a single monetary policy to the euro area, and could give the impression of implicit state financing, which is a big no-no. As such, it would be more likely that a QE programme would need to involve all member states. However, given the likely protestations within Germany and potential conflict with German law, a scenario could arise in which the Bundesbank is not part of a QE programme. We are not constitutional experts, so we are not sure how this scenario would play out.

Aside from the technicalities of implementing such a programme, the impacts are also unclear. With sovereign bond yields already extremely low (the result of the OMT and heavy bond buying by euro area banks) there might not be much bang for the buck in terms of lowering rates much further. Moreover, without structural reform of the banking system and efforts to reviving lending to the euro area, handing over more cash to the banks may not necessarily translate into an improvement in credit supply.

Excess Liquidity Continues To Fall
Eurozone - ECB Excess Liquidity, EURbn

In any case, time is now of the essence. Eurozone inflation continues to slide lower, coming in at just 0.5% y-o-y in March. Although the ECB continues to downplay the risk of deflation, the longer that low inflation persists, the more likely that inflation expectations become anchored at a lower level, which ultimately would weigh further on economic growth.

Interbank Lending Rates Starting To Spike
Eurozone - ECB Excess Liquidity & Interbank Rates

We also warn that secured and unsecured lending rates are starting to become markedly more volatile. Back in September 2013 we warned of the risks of volatility blowback in the euro area in light of passive monetary tightening and the continued reduction in excess liquidity at the ECB, which in the past has coincided with volatility in both secured and unsecured lending rates. As the chart above shows, excess liquidity is back down to levels not seen since 2011 and volatility in lending rates is clearly picking up, which could portend a more pernicious funding squeeze for the banks.

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