Draghi Deflation Fight Seen on Different QE Path to Fed

European Central Bank President Mario Draghi’s version of QE might turn out to be rather different from the type deployed by the Federal Reserve.

As ECB officials try to stamp out the risk of deflation, Draghi yesterday gave his strongest signal so far that the ECB is prepared to embrace a policy that has become a byword for large-scale government bond purchases. And yet, the structure of the euro region’s economy means the ECB will also need to find its own approach to quantitative easing.

Draghi is using the QE label as a tool to convince investors that policy makers in the 18-nation euro region are determined to prevent a Japan-style deflationary spiral. At the same time, there are political and economic obstacles to a euro-wide wave of sovereign-bond purchases, and a program aimed at boosting bank lending may prove to be more effective.

“The ECB is likely to be more focused on buying bank loans than on buying government bonds,” said Elga Bartsch, chief European economist at Morgan Stanley in London. “Given the political and legal concerns around purchases of government bonds, we continue to believe that a consensus on buying private-sector assets would be easier to reach.”

‘Unanimous’ Commitment

Even so, the ECB has already simulated bond purchases of as much as 1 trillion euros ($1.4 trillion) to assess the effect on inflation, a person familiar with the situation said today. The person said there there is no pre-agreement on any QE action or its size.

The euro was down 0.1 percent at $1.3706 at 6:15 p.m. Frankfurt time. The yield on Spain’s 10-year government bond fell 8 basis points to 3.15 percent.

Draghi yesterday said the Governing Council was “unanimous” in its commitment to exploring new policy avenues, including asset purchases.

“There was a discussion about QE, it wasn’t neglected,” he told reporters in Frankfurt after policy makers kept their benchmark interest rate at a record-low of 0.25 percent.

Draghi is trying to steer an economy whose lending dynamics are different to those of the U.S., where deeper capital markets make it easier for the Federal Reserve to guide the economy through asset purchases.

Bank Lending

While U.S. firms tap markets for about three quarters of their lending, companies in the euro region rely on loans from banks for the same proportion of their borrowing.

That makes it harder for the ECB to use asset purchases as a way to improve credit conditions for small-and-medium sized enterprises, the backbone of Europe’s economy.

“The banking system is more essential to the euro area than other financial systems that are more market-based,” Draghi said. Any program “has to be carefully designed in order to take this element into account,” he said.

Buying sovereign bonds is politically and legally difficult for Draghi. The ECB’s founding treaty forbids it from financing governments. 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.

‘Intellectually Ready’

Draghi’s remarks yesterday nevertheless suggest that ECB officials are committed to new measures, whatever the challenges.

“True, we are left with a great deal of confusion as to which market exactly could be targeted, under which conditions, and when,” said Frederik Ducrozet, an economist at Credit Agricole CIB in Paris. Still, “what’s getting clearer by the day is that the ECB is now intellectually ready to react to the risk of a ‘lowflation’ with radical, non-conventional action.”

Draghi may need two months to build consensus on QE, Former ECB Executive Board member Lorenzo Bini Smaghi said in interview on Bloomberg Television in Cernobbio, Italy today.

“A decision by consensus or by unanimity is much more effective on the markets than one with a split majority,” he said. “In his thoughts probably it’s worth waiting one or two months to have a full consensus.”

Inflation Outlook

Options open to the ECB include awarding banks with long-term loans on condition they lend it on to the broader economy. The bank could stop sterilizing the 175.5 billion euros ($241 billion) worth of government bonds it still holds from a previous purchase program, a step that would boost liquidity in money markets.

Or officials could buy private-sector debt. At the same time, Draghi acknowledged that this is more complicated because the market for asset-backed securities dried up during the financial crisis.

The trigger for any ECB action will be consumer price data over the coming months. While Draghi yesterday reiterated the ECB’s forecast that inflation would move toward its 2 percent ceiling by the end of 2016, the rate of price increases is only a quarter of that at present.

This month’s initial report on euro-area inflation is due on April 30.

Dovish Message

“If annual inflation prints rise gradually towards 1 percent in the coming months and medium-term inflation expectations remain stable -- as we and, according to Mr. Draghi, the Governing Council expect -- we expect the ECB to refrain from engaging in further, more aggressive unconventional measures,” said Dirk Schumacher, a Frankfurt-based economist at Goldman Sachs Group Inc., which had forecast the benchmark rate would be cut to 0.1 percent yesterday. “We also no longer expect further easing in policy rates in the coming months.”

Any ECB decision to embark on asset purchases, of whatever shape, will be given added credibility by Bundesbank President Jens Weidmann’s endorsement last week. In an interview with Market News International he agreed to such a step in principle, signaling a departure for the German central bank, that has historically been suspicious of such measures.

Two German policy makers resigned over an earlier ECB bond purchase program and in the summer of 2012, Draghi had to cobble together a plan to save the euro against the opposition of Weidmann himself.

Now, Draghi needs to show what he will actually do after the “verbal pyrotechnics” have died down, said Richard Barwell, senior economist at Royal Bank of Scotland Group Plc in London.

“The Governing Council wanted to deliver a dovish press conference and to do that, the one thing the market really wanted to hear was that asset purchases are on table,” he said. “If they’re forced to do it, they will act, but my feeling is they’ll never get there.”

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