At last week’s ECB meeting ECB President Mario Draghi sent a very dovish message and hinted strongly at further easing. He succeeded in talking down the Euro which has fallen by 3% against the US Dollar since his comments. He also stressed that the ECB will consider “all instruments” at its disposal, including further cuts to the deposit rate. ECB Chief Economist Peter Praet reiterated this line in an interview with AFP yesterday, insisting that there are “no taboos” when it comes to monetary policy instruments.

But to what extent is this true? What tools does the ECB have at its disposal to ease further? The reality is that while it has some options it continues to operate under a number of constraints.

Four main options to further ease ECB policy

There are four main options at play for the ECB in terms of easing policy further and they are all quite similar involving extensions of current policies rather than any fresh approach.

  1. Extend the bond buying programme beyond September 2016 – this is pretty self-explanatory, the ECB would keep buying assets beyond the current forecast end date of September 2016. It also looks increasingly likely with inflation likely to still be well below target by then. How long it would be extended for remains to be seen, but initial bets are on at least six months to March 2017. At current levels this would add a further €360bn of asset purchases to the programme.
  2. Expand the assets eligible for purchase – this would involve expanding the types of assets eligible for purchase under the programme (currently limited to asset backed securities, sovereign debt and covered bonds). There are a couple of ways this could be done. The obvious one would be to extend the purchases to include corporate bonds (probably non-financials) which would (in theory) open up a market of €3.3trn to the ECB. It would also provide another avenue for which liquidity can filter through to businesses given that the current channel does not seem to be working sufficiently. Other assets which could be bought include bank loans or sub-sovereign public debt, though I think an extension to either of these is unlikely and to stocks near impossible (more below). Another way to do this is to expand the list of agencies and international organisations whose bonds are eligible for the public sector purchases. Finally, this could also be done by raising the limit of a single market which the ECB is allowed to buy up from the current 33%, though the ECB would have to explain why it no longer sees this as distorting market functioning.
  3. Raise the overall size of the bond buying programme – this would involve raising the monthly limit on purchases from the current €60bn. Given €60bn was more than many expected originally this would be a big step. But it is worth noting that many of the options are aimed at expanding the scope of purchases, implicitly tackling the problem of scarcity of assets (which I warned of here). As such this would likely be the last option and probably combined with some of the other approaches.
  4. Lower the deposit rate further – this is probably the most intriguing proposition, not least because the ECB previously suggested rates had hit their floor. There are a number of reasons why the ECB may take the deposit rate further into negative territory. The obvious one is that it further discourages people from holding euros and there by lowers the exchange rate. While this was the prevailing logic for instituting the negative deposit rate I think the logic this time around is different. The main reason for doing so, in theory, is that it indirectly increases the available assets for purchase. This is because the ECB cannot currently purchase any assets which yield below the deposit rate (-0.2%). This rules out purchases of a number of assets, particularly at the short end of the curve in the larger states. But why not just remove this rule from the programme? The reason for keeping it is quite technical but it ensures that the ECB does not book a loss on its purchases. This is because any money created to buy bonds always ends up back on the ECB’s balance sheet as excess reserves. These are now charged the negative deposit rate. As such by lining up the deposit rate and the lowest yield on bonds purchased the ECB makes sure it makes up any money via the deposits which it loses on the bonds. You can question whether this is really necessary, but it clearly is desired by the ECB and will likely stay in place. This also highlights why a deposit rate cut does not harm the ECB’s credibility due to reversing a previous position. The deposit rate took on a different role once QE begun. Of course, this approach is not without risks. There is a limit to how negative you can push the rate before people begin just holding hard currency (even with storage costs factored in). Furthermore, it also penalises people for holding excess reserves which are forced upon them under QE, a rather perverse situation. Lastly, while it has not happened so far, at some point banks will probably pass the impact onto retail depositors, which again could have strange impacts and possibly the opposite which the ECB wants in terms of depressing liquidity and hampering consumption.

So which of these might the ECB choose in the upcoming meeting(s)? I have to admit I was a bit surprised at how quickly the ECB has moved towards further easing, though I think this is largely a result of the deterioration in the external environment and the failure of QE to take hold (both of which I warned of). I think the most likely options remain a deposit rate cut (10 basis points to -0.3%) and extending the end date of the programme as well as some tweaks to the eligible bonds. These may not all come in December and could well be spaced out over the next few meetings depending on how things develop.

What about more unorthodox options?

While the ECB has been at pains to try to stress it has a number of options on the table the reality is quite different (this is partly why they are so insistent on pushing back against it). Of course a central bank can maintain a number of more unorthodox policy actions from buying equities to introducing so-called ‘helicopter money’ where it gifts money directly to people. However, the ECB is not just any central bank and it operates under a number of unique constraints, mostly political but some legal.

Ultimately the fact that when QE was eventually undertaken it was shared out amongst national central banks and the fact that it maintains a level between the lowest yielding bond it can purchase and the deposit rate to avoid taking losses both highlight these constraints. The political reality is that some more drastic options are unlikely to ever be acceptable to the Bundesbank and other more hawkish countries. While they could be outvoted the policies would undoubtedly be legally challenged and would seriously erode support for the euro in some of these countries. The legal challenges might well succeed if the unorthodox policies were not shared out via the capital key of the ECB as with QE, thereby hampering their impact as the majority of money flows to where it is least needed.

Will any of this make any difference?

This is ultimately the key question. As I have noted before I think the impact will be quite limited. Looking at the specific options on the table, it seems unlikely they will have a huge impact beyond what we have seen already, not to mention the diminishing returns we have seen to additional rounds of asset purchases elsewhere. A more negative deposit rate could well weaken the currency further though it is fighting a huge Eurozone current account surplus. It is unlikely to much increase the scope of asset available as the market will simply adjust, pushing yields more negative, creating the same problem just at a lower level. In fact there is already some evidence of this happened with two year German bonds already moving more negative towards -0.3% yield and French two year bonds moving below -0.2% level (see chart below). While the euro has weakened it is not clear exactly how and when this will feed through to inflation, as detailed here. Further purchases can boost asset prices but again this is struggling to get through to the real economy and pick-ups in bank lending are very incremental.

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Can QE be both expanded and defined as a success?

Given all the above this is actually quite a big challenge for the ECB and may come to be an issue of credibility. In his AFP interview when asked if QE is effective Praet responded, “With regard to credit, yes. With regard to financing conditions, yes. With regard the economy, yes”. But it is hard to see how it can both see QE as a success and the need to boost it. If it had been achieving its aims then there should be no real need for further easing. Of course, the ECB will likely put forward the argument that external headwinds have increased and while it is working it is doing so slower than hoped, as such more is needed. There is certainly some truth to this argument, but even this is an implicit admission that there are limited things which the ECB can do in the face of a souring external environment and continuing internal Eurozone challenges. As such, the ECB will have to tread a careful line in explaining why further easing is needed, how it will help and why the ECB can still credibly commit to its inflation target.

This is also why I think any expansion will come with a renewed call and pressure from the ECB for more action from member states on fixing the Eurozone. There is already some evidence of this happening. In the end, the ECB knows (and has said often) that it can only do so much and political action is needed. Draghi was once again clear on this at his last press conference. In that sense it is clear the ECB is aware it is running out of road.