ECB Shows Readiness to Flex Rules If Inflation Goal's at Stake

  • Adaptability has become a hallmark of Draghi presidency
  • ECB must sustain stimulus long enough to hit inflation goal

Why the ECB Is Willing to Bend Its QE Rules

In the mission to restore price stability, the European Central Bank is willing to fudge the rules.

That was shown on Thursday when the account of the last policy meeting revealed that officials see a deviation from the capital key -- a measure intended to link quantitative easing to the relative sizes of the 19 euro-area economies -- as “inevitable.” That’s because sticking strictly to the key means having to go after bonds that are in short supply -- and that anyway yield so little that they lock in a loss for the ECB.

While divergences were also considered “limited and temporary,” investors took it as a sign that the ECB will buy more bonds from heavily-indebted nations -- read Italy -- and fewer from countries such as Germany.

Any move toward buying more debt from weaker nations risks stoking the ire of critics who would argue the ECB is assisting one government at the expense of another and undermining the case for economic reform. At the same time, policy makers see a need to ensure that they can maintain their “substantial” expansionary stance in a year where feeble underlying inflation and global risks pose a threat to a still-fragile recovery.

A pragmatic interpretation of the broader framework of monetary policy has been a hallmark of Mario Draghi’s presidency of the ECB. In 2012, as peripheral bond spreads surged, he pledged to do “whatever it takes” to save the euro and followed up with a plan, as-yet unused, to buy the debt of stressed nations. The ECB has so far successfully fought court cases alleging that its bond-buying programs equate to monetary financing of governments, which is barred under European Union law.

Price gains in the euro area jumped around the turn of the year, driven by energy prices, and at 1.8 percent annual inflation is now close to the ECB’s target of just under 2 percent. That said, the rate is likely to fall again later in the year and underlying price pressures still aren’t sustained or broad-based enough for the central bank’s liking.

In that vein, the ECB has been considering loosening its self-imposed rules on QE since mid-2016 to skirt the shortage of suitable assets. In December, when it increased the size of the program to 2.28 trillion euros ($2.4 trillion) by extending it to the end of 2017, the Governing Council decided to remove a requirement that eligible bonds have a yield no lower than the deposit rate, currently minus 0.4 percent, and allowed purchases of debt with a maturity of 1-2 years.

Removing the deposit-rate constraint though exposes the central bank to guaranteed losses, making it a solution that generates new problems.

And at the same meeting, policy makers decided that they couldn’t increase the share of bond issues that the ECB buys without running into legal constraints, a further sign that they are aware of their limits.

Frederik Ducrozet, senior economist at Banque Pictet & Cie SA in Geneva, says that while the latest account suggests that flexibility has increased, the ECB has been making small deviations from the capital key for a while as some national central banks struggle to meet their de facto quotas, and that bigger changes would need to be more formal.

“Now that issue share limits are seen as fixed forever, because of strong legal obstacles, the next shoe to drop should indeed be the capital key, especially if the ECB needs to extend QE into 2018,” he said. “Bending rules, in my opinion, would come with a decision on how much of a deviation the ECB would allow, and would be translated into a new legal act, just like with sub-deposit rate purchases.”

The ECB account shows officials now see “room for a trade-off” between those deviations and limiting the extent of purchases below the deposit rate. The extent to which that trade-off is used should become apparent when the ECB publishes its regular updates on QE holdings. Investors made their views known, selling German debt.

“It will be even more interesting to monitor the amount of monthly purchases to see if the option is used by the Bundesbank in particular, which is the one most concerned by the sub-depo purchases,” said Ducrozet. “Investors are taking positively the hint at more flexibility to come.”

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