Greek Crisis Jolts QE Juggernaut as ECB Ponders Deflation

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European Central Bank Governor Mario Draghi
While European Central Bank Governor Mario Draghi has argued that slumping energy prices may worsen inflation expectations, a development the ECB won’t be able to ignore, a decision in favor of large-scale government-bond purchases still has hurdles to overcome. Photographer: Martin Leissl/Bloomberg

Mario Draghi has more evidence than ever to start quantitative easing as soon as this month -- if only he can find a way to deal with Greece.

Two weeks before the first monetary-policy meeting of the year on Jan. 22, governors gathered yesterday and discussed the decision over dinner. Hours earlier, data showed the first annual drop in consumer prices since 2009 and stubbornly high unemployment, handing the European Central Bank president a stronger case for buying government bonds.

Overshadowing their meal was the return of Greek tensions, with the prospect that elections three days after the coming meeting will bring a party to power that wants to restructure the nation’s debt. That threat adds a new dimension to the argument for Draghi, whose chief challenge in convincing opponents of quantitative easing is to show it won’t turn into a bailout for recalcitrant governments.

“The case for further ECB action is strong and the negative rates of inflation will provide great mood music for Draghi to push QE through the Governing Council,” said Nick Kounis, head of macro research at ABN Amro Bank NV in Amsterdam. “The Greek issue could complicate the announcement and the ECB may well hold off from providing the details until March, giving it a chance to see how the situation turns out.”

Inflation Expectations

Euro-area consumer prices dropped an annual 0.2 percent in December as oil costs plunged, and November unemployment remained near a record at 11.5 percent.

Economic confidence in the region was unchanged last month, whereas analysts predicted an increase, underlining the fragile state of the recovery. German factory orders fell for the first time in three months in November, separate data showed today. The monthly decline of 2.4 percent was steeper than economists predicted.

While Draghi has argued that slumping energy prices may worsen inflation expectations, a development the ECB won’t be able to ignore, a decision in favor of large-scale government-bond purchases still has hurdles to overcome. Policy makers including Bundesbank President Jens Weidmann have spoken publicly against them, citing legal risks and the likelihood that a program would reduce the incentive for governments to reform their economies.

Greek Debt

The treatment of Greek bonds demands particular attention by officials. Greek opposition party Syriza, which leads in opinion polls, has campaigned on an anti-austerity platform that includes relief on the nation’s debt. Data today showed Greek unemployment was 25.8 percent in October.

That poses a dilemma for the ECB, which already owns 8 percent of the country’s bonds. It has also committed to accept the debt as collateral in refinancing operations, despite it being rated as junk by the major credit-rating companies, as long as the country stays in a program to keep its reform efforts on track. The ECB said today its stance won’t change.

“The continuation of the waiver is based on the technical extension of the European Financial Stability Facility program until the end of February 2015 and the existence of an International Monetary Fund program,” it said in a statement. “It is also based on the assumption of a successful conclusion of the current review and an agreement on a follow-up arrangement between the Greek authorities and the European Commission, in liaison with the ECB and the IMF.”

Debt Relief

Executive Board member Benoit Coeure said today that it would be illegal to restructure Greek debt held by the central bank. He also said that the election isn’t a reason to delay a decision on QE, and that any debate about the country leaving the euro area is “meaningless.”

“Greece needs the euro, Europe needs Greece,” Coeure said in an interview with France 24. “There is a very strong commitment from European political authorities to ensure the integrity of the euro area.”

The yield on Greek 10-year debt exceeded 10 percent yesterday for the first time since 2013. It was at 10.13 percent at 6:59 p.m. Athens time today.

Germany is open to discussing debt relief with Greece’s next government, lawmakers in Chancellor Angela Merkel’s coalition said yesterday. While writing off Greek debt isn’t on the table, talks on easing the repayment terms on aid are possible after the Jan. 25 elections, the lawmakers from Germany’s two biggest governing parties said. The condition is that Greece sticks to its austerity commitments, they said.

QE Options

Before then, on Jan. 14, the European Court of Justice will publish an opinion on a previous ECB plan to buy sovereign debt. That case was referred by Germany’s Constitutional Court, which said last year that the central bank probably overstepped its authority with the so-far-untapped OMT program.

The ECJ opinion, while non-binding, “could have some implications for the way in which a QE program was implemented,” BNP Paribas SA economists including Paul Mortimer-Lee and Kenneth Wattret said in a note. “The probability of the ECB opting to shy away from risk sharing is higher than the market is currently pricing in.”

ECB staff are working on various forms of QE, and Chief Economist Peter Praet has hinted at two options aimed at mitigating risks. One approach would be to target only the highest-rated assets, while another would be to make each national central bank exclusively liable for the bonds it buys.

While the second option may address a ban on mutualizing debt and make QE more palatable to the broader public, the purchases could still affect the balance sheets of other central banks. As the money feeds through financial markets, it may create liabilities in the region’s Target2 payment system.

“Whether the ECB will announce QE on Jan. 22 is unclear,” said Torsten Windels, chief economist at NordLB in Hanover. “The election in Greece may be an obstacle, but it may also be an incentive to shield Europe to say: Whatever happens in Greece, the ECB will continue to be active. I’d expect the latter.”

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