Editor’s Note: this post has been corrected to reflect a different interpretation of the Goldman analyst’s remarks.
Ex-ECB economist Huw Pill agrees with many of us that the ECB is unlikely to engage in explicit rate targeting when it announces its policy change in September. But rather than anticipating the ECB’s moving to unsterilized short and medium-term bond purchases in exchange for oversight by the Troika as I do, Pill believes the ECB will target a range. This is an interesting concept, especially given Pill’s having worked at the ECB until last summer. Correction: I now believe Pill is saying the ECB is going to do what I am anticipating it will do. See the updated comments below as to what Pill is really saying.
Pill writes:
The objective would be to develop a better framework for steering short-dated government bond yields towards levels deemed consistent with fundamentals, while avoiding the creation of a ‘one way bet’ situation that can be exploited by markets. This is likely to be achieved by offering more explicit guidance on where peripheral short-dated yields should lie given the state of macroeconomic fundamentals.
To steer market rates towards that level, we expect the ECB to intervene opportunistically in the one- to three-year maturities in the manner of FX intervention, rather than announce ex ante mechanical intervention rules in the style of exchange rate target zones. In our view, such measures can be effective in preventing the periodic spikes in short-term peripheral government yields that have paralysed markets on various occasions in the past few months.
Now, this is more aggressive than what I am anticipating. If you recall, this type of setup was a feature of the ECB’s Bagehot Rule policy I first outlined last July when I wrote:
The ECB could do rate easing. Frankly, I am uncomfortable with any kind of easing but I certainly see some legitimacy in the ECB acting as a lender of last resort here. The ECB would ‘guarantee’ a rate for Italian bonds that is high enough to be a Bagehot penalty spread to Bunds but low enough that it effectively acts as a lower bound for a positive nominal GDP target. This would be liquidity at a penalty rate, say 200 bps to German Bunds, which would be 4.7% right now.
In practice the ECB would want to step in at unpredictable times and buy up sovereign issues below the guarantee rate to ‘punish’ speculators and police the guarantee this way.
I am saying essentially the same thing that Huw Pill is saying except I am defining it as an explicit rate that is range bound by ECB intervention below the target. Pill is saying that the ECB will come out and set a range right from the start. Interesting.
I don’t believe setting a yield target presents a moral hazard either as the source article quotes Pill as saying. The article did not go into specifics as to why Pill believes this would be a hazard but clearly the spread target construction I have set up with the ECB intervening below the target is effectively the same. I would argue my construction is better because it allows the market to set the rate since participants would recognize there is an indeterminate area below the ceiling at which their speculation would be punished. Not knowing what that ceiling is means the rate would be more market-determined with an ECB guarantee at the ceiling. The Pill setup setup I thought Pill was advocating has the ECB setting the rate range and the market moving to that specific range much as with central bank policy rates. That is a more coercive policy and one that will not go over well with those that see the ECB as overstepping its mandate.
I am still sceptical that the ECB would do this straight away. But it is credible given the source.
Source: Business Insider
Update: I was just reading FT Alphaville’s reporting of this and it seems like Pill is actually saying that the ECB won’t set a range at all but simply intervene in potentially unlimited amounts. I now believe he is saying that the interventions without explicit target rates will create less moral hazard because it eliminates a target for markets to bet against. Here’s the key passage:
In our view, the new ECB measures will be more akin to foreign exchange intervention rather than the operation of an exchange rate target zone. The ECB will likely strive to avoid creating a target for the markets to speculate against: ensuring markets face a ‘two-way risk’ rather than a ‘one way bet’ situation will be central. This implies that the ECB would intervene on its own initiative so as to support and amplify market movements that it sees as moving yields towards the levels it sees as consistent with fundamentals. Such interventions need not be pre-announced, even if they are revealed ex post. And the amounts involved would lie within the operational discretion of the ECB. The interventions may be large (indeed, potentially unlimited), but it would be the ECB itself – rather than a need to fulfil a pre-announced commitment to the market – that would determine their magnitude and timing.
And these interventions are likely to be effective. The markets of concern are substantially less liquid than the foreign exchange market – indeed, the fundamental problem is that these markets are seizing up owing to illiquidity, thereby providing the rationale for the ECB to intervene in the first place (so as to support market functioning). At any rate, the short end of the yield curve is the traditional realm of central bank actions and where central bank influence is normally high. Moreover, as we have argued repeatedly in the past, the ECB is a common institution with the power to create an unlimited stock of Euros: there need be no exhaustion of the stock of FX reserves, which ultimately led to devaluations in and withdrawals from the ERM in the early 1990s.
So I take it back, Pill is not making creating a target range coercively. He is eliminating the target altogether and just having the central bank intervene in unlimited amounts. Clearly though that means greater risk for the central bank. If the central bank sets a target and guarantees its defense, it is likely to require less liquidity than if it sets no target and is forced to intervene. If the central bank intervenes in unlimited amounts, traders would end up dumping all of their inventory onto the central bank and the central bank would be stuck with the paper. This is a big problem for two reasons: first, it is a bank bailout in disguise. It gives euro banks a dumping ground for their unwanted paper just as with the Fed in 2008 and 2009 with toxic mortgages. Second, this proposal could subordinate the remaining bondholders to the ECB because the ECB’s claims are senior to other claims as we saw during the haircuts imposed in Greece.
So I don’t like this proposal at all. It is a back door bank bailout that bloats the ECB’s balance sheet with unwanted toxic assets and it subordinates existing bondholders that do not sell out.