Can the ECB do any more?

Inflation in the euro area has been below 2% now for over three and a half years, and the ECB is currently pulling four policy levers in an attempt to get inflation back up to its target level. The first is forward guidance, adopted  by the Governing Council in mid-2013, designed to convince the market that rates will stay lower for longer. The latest wording to that effect states that ‘we continue to expect [rates] to remain at present or lower levels for an extended period of time’ which also flags the possibility of further easing.

In the past the ECB has used official interest rates as its main policy instrument and they are now at historically low levels; the refinancing rate is zero while the deposit rate has been cut to -0.4%. Money market rates are also  negative , including 12-month euribor. Forward rates imply that the market does not expect any upward move in official rates till 2019.

Credit in the euro zone is largely driven by the banking sector ( unlike the US, for example)  and the ECB has also introduced additional measures to boost bank lending , including offering banks long term loans at very low rates. The latest variant (TLTRO II) offers loans up to four years at a zero rate, and banks can reduce the rate paid into negative territory depending on the growth of their loan book. So the ECB would effectively be paying banks to take funds.

Bank lending to the private sector has picked up but is still very weak by historical standards ( the annual increase is currently 1.7%) and so the ECB has sought to influence spending more directly by its asset purchase programme, the fourth policy instrument currently at play. The current plan is to purchase €80bn a month ‘until the end of March 2017, or beyond, if necessary, and in any case until the Governing Council sees a sustained adjustment in the path of inflation consistent with its inflation aim

Inflation is currently 0.4% and the ECB’s staff forecast envisages a gradual acceleration to an average 1.6% in 2018. The consensus market view is that further monetary easing is a virtual certainty, although there is some disagreement about the form that might take. It is noticeable that the Governing Council is now expressing more concern about the profitability of the banking system (at least in the minutes of recent meetings) and fewer analysts now expect a further rate reduction in either the refinancing rate or the deposit rate. It is early days yet for the TRLTRO so any change there is unlikely and so we are left with possible tweaks to QE, including a tapering, although, again, there are a variety of views. Some believe that the ECB may broaden the universe of assets purchased, but in reality that means buying bank debt and/or equities, which may be acceptable for the Bank of Japan but is  highly unlikely , one would think , given the ECB’s constitutional  and operational constraints.

That leaves changes to the current government bond programme, and a majority of analyts believe that the scheme will be extended beyond March, for 6 months or longer. That is not without its problems, however, as in some cases the ECB is at or close to the current 33% issue and issuer limits ( including Ireland) and at various points of late almost half  the available bonds have been trading below zero, with a smaller proportion below -0.4% in yield. A decision to leave the deposit rate unchanged would presumably preclude the latter  and a decision to up the issue and issuer  limits  could potentially give the ECB the main role in any default proceedings, an awkward position for a bank regulator. At the moment the bond purchases are also constrained by the need to adhere to the capital key ( purchases are broadly proportional to each country’s weighting in the ECB’s capital) and again a decision to abandon this may prompt opposition fror the ‘German school’ within the Governing council.

What we do know is that various committess have been set up within the ECB to tease out these matters and examine how QE could be extended if required, but the bigger issue is whether the ECB is at or near the end of its monetary policy cycle. The December Staff forecasts will be crucial and it is worth noting that oil prices are  now higher , which of itself could push the 2018 inflation forecasts to around 2%. The Council also believes its policies have had a significant effect already are are still working through the system. QE has to end at some point, one would think, and the main issue now  is whether it will be in five months or ten.