|ECB president Mario Draghi has argued he will only introduce QE if inflation expectations start falling |
and are not anchored
At its eagerly awaited meeting in June, the ECB finally grasped the nettle and took action to stop the eurozone economy slipping into a Japanese-style deflationary spiral.
The ECB board may not have launched its bazooka of quantitative easing by directly buying sovereign bonds. But its move to negative deposit rates and targeted long-term refinancing operations (TLTROs) for banks to lend on was a clear signal of intent, as were the repeated statements peppering the ECB’s press conference that it was “willing to do more”.
Direct purchases of various asset-backed securities look a likely next step, though full-blown QE (buying sovereign debt) remains on the table, and the ECB will use it if there is any de-anchoring of inflation expectations. However, contrary to the ECB’s views, I reckon inflation expectations are already moving lower. So QE is inevitable before the year is out.
An OK appetiser
As expected, the ECB delivered a loosening of monetary policy (cutting the refinancing rate by 10 basis points to 0.15% and the deposit rate by 10bp to 0.1%). On top of this, it announced an expansion of its balance sheet via TLTROs. It has also evolved its preparatory work for outright ABS purchases, which looks to be the next easing lever it will pull. It might have shirked on delivering the main course of QE, but in sum it is an OK appetiser. QE is still in the arsenal, there to be deployed if conditions justify it.
The four-year fixed rate TLTROs are designed to improve monetary transmission and spur lending to the real economy – which means those non-financial corporates that are reliant on banks for 80% of their funding.
For banks with customers worthy and willing to borrow it’s a free funding lunch – but the easy carry trade into sovereigns is excluded. TLTROs could increase the ECB balance sheet by 20% if the full €400 billion of purchases is made. That would be 7% of commercial banks’ loan books, excluding governments, financial institutions and mortgages.
Adding the components of the ECB’s programme together the potential impact is big. It could surpass the €1 trillion that I have estimated would be needed to reverse euro appreciation. It would represent a 50% increase in the ECB’s balance sheet.
The drawback is that the initiative to take up TLTROs lies with the banks – unlike QE, where the central bank is in control of the amount of liquidity created. The commercial banks are still hampered by the need to improve the quality of their balance sheets under the EU directive. Also there is little loan demand from decent corporations.
Furthermore, the process is stretched out through successive TLTRO auctions and will be heavy in paperwork to ensure the TLTRO is used for the purpose intended. Nevertheless, TLTROs should get the ECB balance sheet growing at a time when the Fed’s is contracting from tapering.
Most important perhaps was the “extraordinary unanimity” of the ECB’s governing council to take these measures and to use more “exceptional measures” as necessary to achieve the ECB’s 2% inflation target. ECB president Mario Draghi said that, as the zero bound in interest rate policy had been reached for all practical purposes, exceptional measures were what remained.
Draghi has argued that he will only introduce QE if inflation expectations start falling and are not anchored. So he is holding fire as he reckons inflation expectations in the eurozone are well anchored.
I do not believe this is to be right – deflation is a real risk. But he did recognize the risks of this prolonged period of low inflation morphing into something worse.
The fact that the QE bazooka was held back, but explicitly kept in the arsenal, probably has more to do with getting any measures through the governing council with extraordinary unanimity than with economic reality. Indeed, speaking of the use of further exceptional measures (including QE) down the road, Draghi said: “We are not finished”.
More will be needed before markets are convinced that the ogre of deflation has been destroyed. So QE is coming and with it will be a sharp fall in the value of the euro.