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On Forbes, Open Europe's Raoul Ruparel examines the ECB's options for futher easing and whether it would have any significant impact.
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.
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.
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.
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.
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.
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.