The ECB recently cut its main interest rate to 0.25% in response to inflation heading further in the wrong direction from the 2% target that forms the ECB’s price-stability mandate. And the rate banks get on funds deposited at the ECB is now zero.
The deposit rate could be furthier dropped into negative territory. Another liquidity-boosting long-term refinancing operation (LTRO) providing ultra-cheap loans to eurozone banks and the ECB’s highly divisive asset purchases programme – outright monetary transactions (OMT) – are also likely to be considered.
However, the fact banks have been repaying existing LTRO lending at the rate of almost €8 billion a week in recent months suggests the uptake would be muted.
Eurozone policymakers have been talking publicly about quantitative easing (QE) as an option in recent weeks, signalling a shift in the stance of the ECB’s governing council on a policy long seen as an anathema to the single-currency bloc.
The view that the ECB’s mandate does not permit supporting European governments by buying their debt has already been jettisoned de facto by OMT.
“If our mandate is at risk, we are going to take all the measures that we think we should take to fulfil that mandate,” ECB executive board member Peter Praet was recently quoted as saying.
However, despite the OECD becoming the latest to back renewed calls for QE as the only viable route to stop deflation and promote growth, opinion is strongly divided over whether it’s the right way to go.
Germany is likely to object on the same grounds it opposed OMT. Its legal challenge to OMT is that it could lead to it having to subsidize another member state if the ECB made a loss on the debt of that state, requiring an injection of capital. Any recapitalization of the ECB would come largely from Germany.
“I don’t think [QE] will be the ECB’s next move – more likely its last,” says Raoul Ruparel, head of research at Open Europe. “QE is a very different kettle of fish for the ECB because it’s actually a surprisingly blunt tool from its perspective compared to, say, in the US or the UK.
“QE would have to be split according to the national central banks’ share of the ECB capital, meaning the largest amounts of QE would be directed to Germany and France, which is obviously not what you want.
“This significantly limits any real benefit in the periphery and could worsen the crunch for safe assets in the eurozone, with the price of core eurozone sovereign debt being driven even higher and returns further down.”
He adds: “It’s also limited in that it can’t buy specific types of sovereign debt, or specific countries’ debt. The ECB could buy a certain maturity of debt, but then it would still have to buy a mixed package across the eurozone, so it would just be a blanket injection of liquidity.
“The fact that you can’t really target it significantly hinders whether the ECB will actually use it.”
Ruparel says one option would be to buy private assets, such as securitized loans, but notes these markets are far less developed than they are in the US or the UK.
At least 80% of euro-area non-financial corporations’ funding is bank loans, as opposed to the bond markets or other types of funding. Unlike firms in the UK or the US, they don’t produce a lot of securities, which cramps the market for securitization.
“There’s not much out there for the ECB to buy and even if it did, it wouldn’t have much impact on the funding structures of these companies,” says Ruparel.
The more developed mortgage-backed securities (MBS) market could be a better bet. However, a substantial portion of MBS are non-performing and lack transparency on quality and price.
The €9.5 trillion eurozone economy is forecast to shrink by 0.4% during 2013, pulled down by the periphery countries but also by Finland, the Netherlands and France – where a nascent recovery seen earlier in the year is petering out – and slowing growth in Germany.
Expected growth in 2014 has been revised down from 1.1% to 1% and inflation will stay well below target in 2014 and 2015 due to record unemployment, lack of consumer confidence and weak bank lending.
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While doomsday scenarios of a break-up with countries having to leave the single currency have receded, a core-periphery, or north-south, divide has become firmly entrenched.
Next year’s expansion of the euro-area economy will be led by Germany, Belgium, Ireland and Estonia, while Greece, Spain, Portugal and Italy will post much lower rates of growth, exacerbating the conundrum facing policymakers.
“I don’t get the sense that they’re panicking yet,” says Dario Perkins, director of global economics at Lombard Street Research. “The decline in inflation we’ve seen is hardly a surprise, given lots of spare capacity in the economy, very low wage growth, and rising unemployment.
“It’s going to come down to whether this recovery they’ve been expecting for so long materializes in 2014. If instead the economy is still stagnating and inflation expectations are starting to drift lower, that’s the point at which they come under a lot more pressure to do something more radical.”
He adds: “By spring time we’ll have a pretty good sign of whether the economy is improving in the way they’ve been telling us it will or whether it’s just flatlining. I think it’ll flatline. The situation has stabilized, but there’s not really any sources of growth.”
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Perkins is sceptical of negative rates achieving much because rather than redirecting funds to the private sector, banks could simply pay to leave funds on deposit and offset the cost through a premium on the loans they do issue.
“If they really want to address deflation risks, they’ll have to go for QE at some point and it’s going to come down to inflation expectations,” he says. “Clearly inflation’s fallen more quickly than they thought it would, but what will worry them are any signs that the low inflation rates are starting to feed through into expectations.
“Those expectations have drifted down recently, based on market bond yields, but they’re still positive. The danger is if they continue to fall. That’s probably the most likely trigger for something resembling QE.”
Philosophical and political opposition to QE might be strong, given worries about the technical obstacles, dangers and moral hazard – encouraging irresponsible behaviour in the knowledge there will always be a safety net.
However, if deflationary pressure spreads from the periphery to core countries and deflation becomes more widespread, QE can’t be ruled out because the ECB’s mandate dictates that it take action.
Germany will doubtless put up stiff resistance, but there has been a growing precedent for pushing aside the views of Berlin in the two years Mario Draghi has presided over the ECB. A simple majority on the ECB’s 23-member governing council is all it would take.