Draghi Watches as BOJ Yield Curbs May Give ECB Food for Thoughtby
ECB’s problems similar to those Bank of Japan aims to solve
Draghi faced with 19 yield curves versus one for Kuroda
As the Bank of Japan pushes monetary policy closer to its limits, Mario Draghi is likely to be watching carefully.
Like his BOJ counterpart Haruhiko Kuroda, the European Central Bank president is finding his extraordinary measures to combat low inflation are hurting banks, draining the bond market and flattening the yield curve -- outcomes that threaten to impede or even reverse the impact of his monetary stimulus. Kuroda’s response on Wednesday was to revamp the BOJ’s strategy by effectively skewing the focus of its asset-purchase program toward shorter-maturity securities, as well as pledging to overshoot on his 2 percent inflation target.
“The BOJ has effectively raised its inflation target and more or less solved the scarcity issue by making sure it doesn’t have to spend blindly but can pick and choose to buy where it needs,” said Richard Barwell, an economist at BNP Paribas Investment Partners in London. Kuroda’s approach “is courageous and definitely something very interesting for the ECB looking ahead, but the question is whether Draghi would be able to say ‘we can do it too if we need to’ given the current institutional set up.”
The Frankfurt-based ECB has sent euro-area yields plunging with negative interest rates and a QE program that buys 80 billion euros ($90 billion) a month of public and private debt. For banks, which borrow short to lend long, that’s a squeeze on profitability. The ECB’s actions may have stopped a decline in euro-area lending, but credit growth is slow and bank stocks have slumped -- while inflation remains far below the goal of just under 2 percent.
The ECB currently aims to match the average duration in the market to avoid distortion. Buying more shorter-maturity debt would be stymied by a rule limiting QE to bonds yielding more than its deposit rate of minus 0.4 percent, but that restriction is under review. A bigger problem could be the implementation of a BOJ-style program. Kuroda has one country to deal with; Draghi has 19.
“The ECB has 19 yield curves to look at,” said Marco Valli, an economist at UniCredit SpA in Milan. “The fact that there isn’t a single jurisdiction makes it difficult for the ECB to follow in the steps of the BOJ. Even if it were legally feasible, it would be politically difficult to sell.”
Another problem would be that controlling spreads might fuel criticism Draghi is helping governments of weaker nations finance themselves cheaply, which is illegal under European Union law. It’s an accusation often thrown at the BOJ, and its newest policy does nothing to counter that.
“What the BOJ did is another step toward monetary financing,” said Frederik Ducrozet, an economist at Pictet & Cie in Geneva. “Now you have a cap on yields and this is a wartime monetary policy in peace times.”
Capping yields is not unprecedented, Ducrozet said. The U.S. did it during World War II, when the Fed and the Treasury agreed to limit long-term bond yields at 2.5 percent, with ceilings imposed also on other points of the curve.
More recently, the U.S. Federal Reserve under Ben Bernanke in 2011 sought to reduce borrowing costs by buying longer-term Treasuries, while selling shorter-term securities to flatten the yield curve. The plan was termed Operation Twist, reprising a name used for a similar strategy in the 1960s.
Some economists suggested the Bank of England might also target the yield curve when it resumed QE after the U.K. voted to quit the European Union. In the event, the BOE opted not to go that route.
European policy makers don’t yet face the kind of sustainability challenges for QE that Kuroda did. If the BOJ continued with the current pace of 80 trillion yen ($795 billion) annually, it would exhaust the entire supply of government debt within several years. The central bank noted Wednesday that the monetary base is now equivalent to about 80 percent of the economy’s size -- compared with roughly 20 percent in the euro area and U.S.
The latest changes set up the Japanese central bank’s policy for the long haul -- all the better given that economists don’t foresee it hitting the inflation target for years to come.
The second part of the BOJ’s new strategy is one that Draghi might find more useful, yet equally hard to get past the 25-member Governing Council. The BOJ’s plan to overshoot the inflation target for a while echoes the idea by Nobel Laureate Paul Krugman that in a liquidity trap, a central bank should “credibly promise to be irresponsible.” Draghi cited that phrase in a speech in 2015 as his QE program got under way. It would be consistent with his pledge in 2012 to do “whatever it takes” to save the euro.
Euro-area inflation has undershot the ECB’s goal for more than three years, and the central bank has repeatedly extended its forecast for when it will get there, with the latest prognosis for late 2018 at best. Even then, question marks might remain over whether the pace of consumer-price gains can be sustained if monetary policy normalizes.
“Committing to overshoot in the future is on page one of the academic playbook for escaping a deflation trap so I’m sure Draghi would do the same given a free hand, but he faces a Herculean task in convincing the Governing Council,” said BNP’s Barwell. “By demonstrating what a courageous central bank can do if it is determined to achieve its inflation target, Kuroda has inadvertently put Mr. ‘Whatever It Takes’ in an awkward position.”