On an ECB tax on reserves, QE and other easing

What is the ECB likely to do come June? There has been a lot of speculation in the media about the ECB’s next move but the ECB has yet to make definitive statements on which way it is leaning and why. I believe quantitative easing is out of the question but I also believe the ECB is likely to ease in some manner come June.

The latest economic data points tell the story. First, there is industrial output. Eurostat, the European Union’s statistics agency said Wednesday that industrial production for March 2014 was down 0.3% compared to February, and down 0.1% compared to March 2013.

The figures suggest no growth in industrial production in the eurozone for the entire first quarter. Now, Eurostat figures to be released tomorrow are expected to show the eurozone economy expanding in the first quarter for a fourth straight quarter. Median estimates polled by the WallStreet Journal are for a 0.4% pickup. However, while consumer demand has been strengthening and exports are picking up, the industrial production number is another figure showing sluggish growth at best.

Then, there were the inflation figures. A number of statistics agencies in the largest eurozone countries released inflation numbers for April today. And they show inflation increasing 0.7% in April, up from 0.5% in March. While this figure is still well below the ECB’s target of 2.0%, it was higher than the previous month. So the question now becomes what does the ECB do with these data.

Because this was the sixth straight month of sub-1.0% inflation, Germany’s central bank, the Bundesbank, has already thrown in the towel. It will back stimulus measures from the ECB in June to keep inflation from tipping into deflation.

The key here will be the ECB staff inflation projections for 2016. If they show inflation remaining low, then the ECB will have a green light to ease. I believe they will show low inflation and so the ECB will ease in June. But what will they do?

The ECB has a single mandate, price stability. However, Mario Draghi has previously said that price stability implies a rate of inflation consistent with maintaining the ECB’s long-term inflation target. With inflation lower than target, the ECB therefore not only has greater leeway to act as it wishes, it also has a mandate, according to Draghi, to act to push that rate toward the target in the way it best sees fit.

Beyond inflation, other externalities therefore come into play. There is money market liquidity, credit markets, the exchange rate, and economic growth. All of these will affect inflation. If money market liquidity is poor, banks will not grant credit. If credit growth is poor, it will most likely affect households and SMEs where debt levels are still elevated and debt stress is acute. That will retard consumer demand, economic growth and inflation. If the euro is too high, as some are concerned it is, export growth from internal devaluation tactics in the periphery will be less robust. And clearly, the biggest bogey is growth itself. Without growth, the inflation target will be undershot again and again.

In my view, the biggest problem for the ECB here is money markets and credit because while the ECB’s ‘anything it takes’ strategy has caused sovereign yields in the periphery to plummet, corporate yields in the eurozone are still elevated. This is a disconnect that says that liquidity and credit markets are not robust. And therefore, to the degree the ECB staff inflation projections allow the ECB, it will use this as a rationale for easing.

There are five options for easing then:

  1. The ECB could lower rates.
  2. The ECB could allow its balance sheet to rise. The ECB has been sterilizing the 170 billion euros of government bond purchases it previously made during the European sovereign debt crisis. It could allow these purchases to become unsterilized.
  3. The ECB could charge banks for holding reserves, essentially taxing them for having reserves.
  4. The ECB could also actively look to purchase assets to expand its balance sheet, whether those assets are government or private sector bonds.
  5. The ECB could set up another low rate credit facility for banks but with the specific mandate for banks to increase lending to SMEs and households.

The greatest noise so far has been around the fourth option. I don’t see the ECB doing QE. Yes, they are talking about it. But there are too many institutional obstacles to making this a likely first option. The no monetization clause in the Lisbon Treaty article 123 is the problem with buying government bonds. And I think it unlikely that the ECB has got consensus around other assets to purchase. If you listened to Draghi at the last press conference it was clear he was perturbed about all the public pressure to do QE. And I took this as a sign that there were elements within the ECB that were less likely to be accommodative if they were exposed to such vociferous political pressure. So QE is out I say.

Lowering rates is easy to do, if ineffective. SO I see this as a gimme on some level. But because lower rates will be seen as insufficient, it is likely that another form of easing gets implemented. Die Welt, a German newspaper, says that the ECB is preparing for an easing round in June and specifically that the negative deposit rate solution has been thoroughly investigated. That tells me this is a likely option in conjunction with lower rates. But according to an ECB insider, “we are preparing a series of things”, meaning it may not just stop there. The insider went on to say, “We could lend money to the banks again, but for a longer period, possibly with stipulations. We could reduce interest rates again. A combination of several instruments of monetary policy is possible.”

So there you go; the ECB is ready to act and I believe it has already garnered enough consensus around lowering rates and doing something more. That something more is likely to be either a negative rate for reserve deposits and/or a new lending facility with strings attached. QE is the least likely option in my view.

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