An Update on the ECB
The European Central Bank (ECB) is getting much closer to what many analysts believe is the inevitable launch of a much broader-based program of asset purchases, also involving sovereign bonds. While it is true that the ECB remains a much more politically sensitive central bank than some of its main counterparts and what big stakeholders, such as the German central bank and government, think matters, it is now clear that the president of the Frankfurt-based institution, Mario Draghi, has decided to act solely based on its mandate and data rather than politics.
Inflation will in all likelihood remain weak or even weaken in coming months. Furthermore the current purchases of asset-backed securities (ABS) and covered bonds, coupled with the very generous liquidity injections offered through its targeted longer-term refinancing operations (TLTROs), will probably fail to significantly increase the size of the ECB’s balance sheet. Ultimately, the ECB will be forced to change the composition of its asset purchases to include corporate as well as government bonds. This would not represent a departure of the bank from its mandate, but rather a stronger focus on it.
The ECB has only one mandate—price stability—and given stubbornly low inflation readings, the risks of failing to act—also in term of the central bank’s own credibility—are much bigger than those of acting. However, I doubt that the governing council will be ready to act at its December meeting, given the fact that the ECB only started to purchase ABS on November 21 and the second tranche of TLTROs will only be allotted a few days after the gathering.
My baseline scenario is that it will decide to launch a mix of corporate and government bond purchases between January and June of next year, when it becomes clear that current measures are insufficient to significantly increase the size of the ECB’s balance sheet and inflation will still be too low.
These purchases would not represent a new program per se, but rather a dramatic expansion of what the ECB is already doing.
Regardless of the understandable criticism against the merits of quantitative easing (QE) and its impact on lending and the real economy, let’s not forget that from a purely legal standpoint such purchases are easier to shield against legal challenges. QE is “merely” an unconventional monetary tool while OMT (outright monetary transactions, launched in 2012 that protected the integrity of the euro zone) can in fact be interpreted as blurring the lines between fiscal and monetary policies—as the German Constitutional Court made clear. How QE is designed will therefore matter, both from a monetary as well as from a legal standpoint. Doing it right will simply take some time.
I see a higher probability for a decision at the central banks’ March meetings in Cyprus or in April, just before the spring meetings of the IMF and World Bank. This would give the ECB enough time to assess incoming data and determine whether the ABS/covered bonds purchase programs, coupled with the TLTRO tranches of December 2014 and March 2015, are having enough of an impact. If nothing happens by June, it would mean that the need to act has receded very significantly. However, this means that inflation needs to reverse its downward trajectory substantially in the coming months, which is currently unlikely to happen.
In a speech in Frankfurt on November 21, Draghi made a strong case for QE: “We cannot be complacent,” he said, “We have to be very watchful that low inflation does not start percolating through the economy in ways that further worsen the economic situation and inflation outlook.” He added that “any de-anchoring of expectations would cause an effective monetary tightening—the exact opposite of what we want to see. […] For our part, we will continue to meet our responsibility—we will do what we must to raise inflation and inflation expectations as fast as possible, as our price stability mandate requires of us.”
Between March and June of this year, the ECB was already forced by incoming data to revise its inflation forecast downward, from 1.0 percent to 0.7 percent in 2014, from 1.3 percent to 1.1 percent in 2015, and from 1.5 percent to 1.4 percent in 2016. In November, the EU Commission adjusted its own estimates to a mere 0.8 percent in 2015, far off the inflation target of the ECB of below but close to 2 percent. The ECB could revise its own estimates in December and admit that it won’t meet its targets in 2015. Alternatively, it could stick with the current forecast and have to admit failure later. In neither case would it be easy to argue that inflation expectations are still well anchored over the medium term. They may well be, but below target.
To conclude, if inflation data are the only benchmark for future decisions, chances of avoiding the need to expand the ECB’s asset purchase program are dwindling fast.
That is why the recent Draghi speech in Frankfurt matters. It closes a phase that he opened with his speech at the central bankers’ gathering in Jackson Hole last summer. For months, Draghi insisted on the need for a comprehensive strategy, consisting of fiscal, structural, as well as monetary policies. He sometimes confused investors by implying that monetary policy could in essence not do whatever it takes to save the euro, at least not from stagnation. But he had to do all of this in order to lay the political groundwork for what is likely to come.
Having warned politicians that if they fail to act, this could harm the effectiveness of the central bank’s policies, he is now asking them not stand in the way; in fact, “as monetary policy works on the demand side of the economy, other policies can assist in this process—or at least not counteract it. This means that the aggregate fiscal stance of the euro area has to be consistent with our position in the cycle. And it means that this fiscal stance must be achieved in a confidence-enhancing way—that is, consistent with the fiscal governance framework—otherwise lack of confidence will undermine investment and offset the positive effects of fiscal policy on demand.”
What is now clear is that the ECB will act, regardless of political misgivings and the fiscal stance in various euro area member countries. It just so happens that without some help from politicians, the central bank could end up only achieving a slight pick-up in inflation, not necessarily enough to provide the substantial boost that the euro area economy needs.