Is Europe's Economy So Bad the ECB Will Run Out of Things to Buy?
With European Central Bank President Mario Draghi hinting at further easing by the central bank next month, markets are busy trying to work out whether the next move will be to lower deposit rates even further into negative territory or ramp up asset purchases. Or perhaps both.
The terms of the ECB's quantitative easing, or QE, program mean that it theoretically has a fixed universe of assets to purchase - a limit that could be hit earlier than its intended September 2016 deadline if the bank substantially increases the size of its purchases.
Under its current rate of 60 billion euros ($65 billion) a month, the ECB should be more than capable of purchasing the 893 billion euros of agency and government bonds with yields above the deposit rate planned through next September.
However, if the rate of purchases is ramped up then it could come close to running out of available assets, according to Bloomberg Intelligence economist David Powell.
Instead, he said, the ECB could cut the deposit rate to increase the investible universe of assets, as well as significantly increasing QE purchases.
"BI Economics calculates that a decline in bond yields of 25 basis points across the curve would shrink the universe of bonds to 1.3 trillion euros," he said. "In that instance, a cut to the deposit rate would be required to implement asset purchases of 90 billion euros much beyond September 2016 - the total through September would be roughly 1.2 trillion euros of overall purchases of agency and government bonds."
Problems With the Plan
Rather than relying on a rate cut to free up assets, the ECB could simply shift the mix of purchases to agency debt, corporate debt, or even debt from other countries. In December last year, Draghi directly addressed the issue of eligible assets under the ECB's QE program.
Asked whether the board had discussed buying gold or U.S. Treasuries, he replied:
"On what sort of assets should be included in QE, my sense and recollection is that we discussed all assets, but gold."
In other words, asset scarcity should not be a problem. However, lowering the deposit rate might be.
As Pictet argued in a recent Q&A:
"With excess liquidity at €500 billion, a -0.20 percent negative rate represents a €1 billion tax on the banking system on an annualized basis, and a 10 basis point rate cut would add an extra cost of €500 million. Assuming surplus liquidity rises towards €1,000 billion eventually as QE proceeds, a -0.30 percent deposit rate cut would represent an annualized ‘tax’ of €3 billion."
Given that it is already set at -0.2 percent, a further drop could squeeze European bank profit margins and potentially pose financial stability risks. This, Pictet notes, may lean against regulatory efforts to strengthen European bank balance sheets and provide a tailwind for lending to households and corporates.
Moody's ratings agency has already warned that savings banks, which rely heavily on customer deposits as a source of funds, are seeing their margins squeezed with interest charged on new loans falling but rates paid on deposits sticking above zero to prevent people from pulling out their savings.
In order to protect their margins it is possible that moving further into negative territory could mean banks charge higher interest rates on new loans.
Moreover, even if there were asset scarcity constraints it is not clear that deposit rate cuts could more than offset additional QE purchases.
Weak Eurozone inflation data has already seen yields on government bonds reverse earlier increases in the year on expectations of further ECB action. So an ECB deposit cut might, at best, ensure that the universe of eligible assets doesn't shrink.
At its best, it may increase the amount of available assets somewhat and provide some insurance against further yield declines.
If the market expects the ECB to lower rates or increase purchases again in future, then yields on some eligible assets could be pulled below the deposit rate. This could undermine the effectiveness of the cut entirely.
The end of open mouth operations?
Powell suggested that one way around this problem is if the ECB got rid of the threshold that prevents it from buying assets with yields below the deposit rate. In theory, that could free up a potential universe of 2.4 trillion euros of assets - well beyond the central bank's current needs.
That would face significant practical obstacles, however. In March Benoît Cœuré, a member of the ECB Executive Board, gave a speech explaining the rationale of limiting QE purchases to assets with yields above the deposit rate.
He said (emphasis added):
"This decision has two implications. First, it provides a strong commitment by the Eurosystem to implement the PSPP in all eligible jurisdictions. Second, it curbs expectations about future government bond yields falling below the deposit facility rate, which could ultimately have a negative effect on banks’ incentives to sell government bonds."
So the ECB faces a difficult balancing act to signal its firm intention of getting Euro Area inflation back toward target, while simultaneously ensuring that it maintains sufficient policy flexibility to deal with any future shocks.
According to Pictet, Draghi is hoping that the mere prospect of a deposit rate cut pulls down the trade-weighted value of the euro to reduce imported deflationary pressures. This could provide some breathing room as falling oil prices work their way through the economy, but is also vulnerable to a sharp reversal if the board fail to follow through.
There's still one get-out clause. With Euro Area confidence indicators picking up, it's possible that by December the outlook will have improved sufficiently to avoid the need for a rate cut altogether.