ECB Delivers More Than Expected


ECB announces larger than expected bond buys that will continue until inflation moves back towards target.

Mindful of the weight of market expectations, the European Central Bank surprised today by delivering a larger and potentially much longer lasting bond purchase scheme. With markets expecting the Asset Purchase Programme to amount to €500-600bn, Mr Draghi indicated that the ECB would undertake monthly purchases of €60bn per month and these would last from March of this year until ‘at least’ September 2016, implying a minimum cumulative purchase of €1140bn.

Arguably of greater importance, Mr Draghi indicated that purchases would continue until the Governing Council ‘see a sustained adjustment in the path of inflation which is consistent with our aim of achieving inflation rates below, but close to 2% over the medium term. In a sense this amounts to a ‘whatever it takes’ type commitment to restore inflation to a much healthier trajectory. The open ended nature of the programme is clearly intended to work through the ‘confidence’ channel and affect market sentiment by emphasising the ECB’s determination to meet its inflation mandate.

Lower TLTRO Rate May Also Help Boost Balance Sheet

To encourage additional lending capacity, the ECB also announced that it was removing the 10 basis points premium over its main refinancing rate that it charges for any funds borrowed in its Targeted Longer Term Refinancing Operations (TLTRO’s) between now and the middle of 2016. This is intended to address the disappointing uptake in the two TLTRO’s already undertaken and should assist the delivery of the intended increase in the ECB’S balance sheet, which Mr Draghi indicated ‘will further ease the monetary stance’.

Mr Draghi justified today’s decisions by saying they were ‘...taken to counter two unfavourable developments’. The two were weaker than expected ‘inflation dynamics’ and the absence of a ‘material improvement’ in terms of ‘quantitative results’ from the policy measures undertaken between June and September last year. While today’s announcements will buy the ECB significant time, particularly as the Asset Purchase Scheme will not start until March, markets will pay even more attention than usual to trends in inflation and the ECB’s balance sheet in coming months.

"Measures Should Weigh On Euro FX Rate And Bond Yields. Market reaction to today’s ECB decisions will initially focus on the larger and potentially longer commitment to asset purchases. So, the immediate weakening of the exchange rate and broadly based decline in bond yields are not surprising particularly as the past twenty-four hours had seen some firming in both on concerns about the scope for an underwhelming announcement from Mr Draghi."

To the extent that future Euro area data are surprisingly disappointing or strong, the natural impact on the exchange rate and Euro interest rates of such developments will be amplified by what this implies both for the length and possibly the scale of the asset programme in the future. This may suggest a little more volatility in these asset prices even if the immediate and continuous presence of the ECB as a major prospective purchaser represents an important limiting factor on upward movements in bond yields.

We would also note that the introduction of the expanded Asset Purchase Programme makes it altogether easier for the ECB to respond to any unforeseen negative developments in coming months, as it can do so by increasing the scale of asset purchases rather than having to embark on the clearly tortuous path of introducing new forms of policy action.

Questions Persist As To Whether QE Will Work

If there are many reasons for markets to welcome today’s decisive ECB announcement, it must be remembered that there are many theoretical and empirical reservations as to how successful it may be in moving the trajectory of activity and inflation in the Euro area  to a less worrisome path. While the scale of today’s asset purchase scheme is impressive, it has to be recalled that debate continues as to the exact scale of impact a succession of QE schemes has had on the US economy where capital markets are the predominant source of funding. As a result, any impact on the Euro area economy from today’s ECB actions is unlikely to be spectacular or immediate. We still see risks that GDP growth might struggle to reach 1% in 2015 and a negative inflation rate for the year as a whole is also a strong possibility. That said, today’s measures could provide the incremental spark necessary to push economic conditions in a more positive direction.

Most of the technical details of the new Asset Purchase Scheme were framed with a view to giving it as broad a traction as possible. So, for example, the ECB can purchase assets with ‘a minimum remaining maturity of 2 years and a maximum of 30 years at the time of purchase’. It can also purchase securities that currently have a negative yield while the ECB also ‘accepts the same (pari passu) treatment as private investors’.

Risk Sharing Issue Remains A Problem

There is one aspect of today’s decision that may pose significant problems for the ECB. That is the vexed issue of risk sharing.  Just 8% of sovereign bond purchases bought under the programme announced today will be subject to loss sharing. Loss sharing will also apply to securities of European institutions which will constitute a further 12% of assets purchased under this programme. While Mr Draghi tried repeatedly to downplay the significance of this issue and manfully emphasised the ‘singlenesss’ of the ECB’s policy, the virtual absence of loss sharing is seen as a clear signal of the inability of the Euro area to function as a true economic and monetary union.

As we noted in our briefing in advance of today’s ECB meeting, the debate around loss sharing is, to a significant extent, the battleground of choice in the broader war over the merits or otherwise of QE in the Euro area as well as a touchstone for deep concerns in some parts over the possibility of fiscal transfers through monetary policy actions.The arguments in relation to loss sharing tend to be more theological than technical as the nature of Central Banks fundamentally alters the implications of any losses they might book. Constraints on loss sharing were in part an awkward compromise to allow a sizeable asset purchase scheme be announced today.

Mr Draghi expressed surprise on several occasions today at the extent to which there is a focus on loss sharing but he is clearly aware of the extent to which this issue resonates with some of his colleagues. He noted that all monetary policies entail fiscal consequences but said the ECB was operating under ‘the principle of monetary dominance’. Our sense is that any one of a range of concerns regarding the divergences in the performance of national bond markets through the coming year could see this issue assume even greater importance.

Benefits To Ireland May Be Mainly Indirect

The ECB noted that it would apply an issue limit to purchases of securities. While we were unable to get clarification from the ECB today on the precise form this will take, it would appear that the Irish Government bonds that the Central Bank of Ireland holds arising from the wind-up of the Irish Bank Resolution Corporation together with ECB holdings of Irish bonds from the Securities Market Programme will constrain the ability to purchase Irish Government bonds through the new Expanded Asset Purchase Programme. Indeed, some in Frankfurt probably see the exchange of Irish Government bonds for promissory ECB Delivers More Than Expected22 January 2015 5 notes through the deal done in February 2013 as a uniquely Irish version of Quantitative Easing that is already bearing fruit.

Furthermore, the portfolio balancing channel which is regarded as central to the workings of QE should prompt downward pressure on Irish bond yields indirectly in response to lower yields elsewhere. More generally, the Irish economy should also benefit significantly from related softness in the exchange rate of the Euro. Finally, a somewhat healthier euro area economy would also contribute to Irish economic growth. As a significant ECB action was anticipated and most of the benefits of this Asset Purchase Programme may take time to feed through to the ‘real’ economy, we are not making any change to our forecast of 3.5% GDP growth for Ireland in 2015 at this point.