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Draghi’s $1.4 Trillion Question Lingers as ECB Mulls QE

ECB President Mario Draghi
Mario Draghi, president of the European Central Bank (ECB), pauses during a news conference at the bank's headquarters in Frankfurt on April 3, 2014. Photographer: Ralph Orlowski/Bloomberg

When Mario Draghi flies to the U.S. this week, he’ll leave a 1 trillion-euro ($1.4 trillion) question mark hanging over Europe.

While the European Central Bank president and other ECB policy makers can use the International Monetary Fund meetings in Washington to reiterate their willingness to use quantitative easing, they may be unable to say much on its design. That suspense risks setting investors up for disappointment, according to economists at UniCredit SpA and Deutsche Bank AG.

Draghi can expect intense scrutiny of the policy option he divulged on April 3, with the pressure heightened by the revelation that the ECB has simulated an anti-deflation QE program deploying as much 1 trillion euros in bond purchases. Even so, Executive Board member Yves Mersch and Governing Council member Jens Weidmann signaled that there is plenty still to be discussed, and Governing Council member Ewald Nowotny indicated that purchases may focus on private securities rather than public debt.

“All this talk about QE has gotten markets rather excited,” Erik Nielsen of UniCredit wrote in a note yesterday. “I am sure the ECB -– like most of us -– is happy about this, but action is not imminent. What happens when markets realize that this was all just a semi-public discussion of the toolbox - – and not what will happen, unless we get an emergency?”

Multiple Models

Draghi may face questions on the matter at a press conference on April 12 as he attends the IMF spring meeting. Vice President Vitor Constancio will also fly to the U.S. this week, as will board members Peter Praet, the chief economist, and Benoit Coeure, the markets chief.

The ECB president’s comment last week that the Governing Council is “unanimous” on exploring tools including asset purchases prompted a surge in euro-area bonds, with Spain’s five-year note yields falling below U.S. equivalents for the first time since 2007. The Spanish yield was at 1.73 percent today, compared with 1.68 percent for the U.S. bond.

The ECB has run multiple QE models, a person with knowledge of the matter told Bloomberg News on April 4. Earlier that day, Frankfurter Allgemeine Zeitung reported that the institution tested buying about 80 billion euros a month over one year and found that it could boost inflation by between 0.2 percentage point and 0.8 percentage point. The newspaper also said officials are leaning toward a credit-enhancing program.

Raising Expectations

Those models may represent only some of the options being evaluated. Coeure said in an April 4 interview with Le Figaro posted on the ECB website today that a European QE would be different to the one run by the U.S. Federal Reserve. Constancio said in Brussels that the ECB’s working groups are “considering many hypotheses” and no decision has been taken on QE. Mersch said in London that the program is a “theoretical concept” that could be a long way off.

“It’s not enough to try and establish models,” Mersch said. “From the theoretical agreement to the operational implementation it’s a long way, and this is the way we intend to go.”

Buying sovereign bonds could be politically and legally difficult. The ECB’s founding treaty forbids it from financing governments, and Draghi would also have to choose which countries’ bonds the central bank should acquire.

If the ECB were to purchase debt proportionate to the size of its member countries, more than half would come from nations like Germany and France. Targeting peripheral countries could undermine efforts to make them rein in spending.

Legal Issues

“We think that the central bank has raised expectations so much that it will be compelled to act,” Deutsche Bank economists including Peter Hooper wrote to investors yesterday. “The risk then is that the market is disappointed.”

While the path to QE appeared to have been smoothed last month when Weidmann, who has expressed reservations about bond purchases, said they are not “generally out of the question,” the Bundesbank president today said he hasn’t changed his position. Any program is only permissible if it doesn’t constititute financing of governments, which European Union law bars the ECB and national central banks from doing, he said.

“I gave an interview to a newswire which I think was widely interpreted by people who hadn’t read it,” Weidmann said. “This is a discussion we have to have in the Governing Council. And I think you can expect this discussion, but I think you can expect me to be consistent again and to apply the same benchmarks, the same criteria that I had so far.”

ABS Market

Nowotny said today that there is no immediate need for ECB action and his preference for unconventional measures is to bolster the market for asset-backed securities.

“I’d prefer measures that are as close to the market as possible -- for that reason I’d see measures to strengthen the ABS market in Europe as the first relevant measure,” Nowotny said at an event in Vienna. “That doesn’t mean that other steps are ruled out, but my personal emphasis would lie in this area.”

Draghi said last week at his monthly press conference that the ECB supports efforts to revisit crisis-era regulation that made ABSs unpalatable to investors, while recognizing that it isn’t easy to design a QE program based on private debt.

“What happens when markets realize that we are talking private assets, of which I seriously struggle to find 1 trillion euros?” UniCredit’s Nielsen said. “I really think that we are in for a disappointment –- not caused by deliberate bluffing, but by the complexity of transparency.”

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