Has Central Banks' Omnipotence Come To An End?

Source: European Central Bank

Overall, the effectiveness of increasing government bond purchases is limited: the yield curve has flattened considerably, the recent lengthening of the period over which the ECB will conduct purchases had hardly any effect on inflation expectations, and continuing pressure on banks’ profits could jeopardize their intermediation capacity.

An alternative option would be to move towards purchases of other asset classes. Experience in both the US and the euro area shows that QE works through the asset side and portfolio rebalancing. The important thing is not how many bank reserves (or how much base money) are created, but which assets are bought. The portfolio balance effect works by substituting one type of assets (long term bonds in the US and bonds as well as, in small amounts, asset-backed securities in the euro area) with an asset having very different characteristics, such as bank reserves.

So, if the ECB wished to give a new edge to QE it would be well advised to impart a new twist to its purchases, and venture into new assets.

The ECB could purchase a number of new assets. Adding corporate bonds to the purchases would be relatively easy. The market is relatively small in the euro area, but the “novelty factor” would be limited.

There would likely be a bigger novelty factor if the ECB bought senior bank bonds, and even more if it bought junior bank bonds. But it would be a bad idea for the ECB to further load itself with banking risk, not to mention the conflict of interest that would derive from its double role as bank supervisor.

In addition, it is not clear that continuing to insist on the banking channel to transmit the monetary policy impulse is the most efficient approach.

Purchasing equities, in the form of a broad market index, would undoubtedly have a strong novelty effect. This would be a bold move for a central bank like the ECB, even if there are the precedents of the Bank of Japan and the Hong Kong Monetary Authority. Another factor that would have to be taken into account is that equity risk would be added to the balance sheet of the Eurosystem.

Asset-backed securities (ABS) with non-performing loans as underlying assets could also be added to the purchase programme. However in this case it is not clear if this is a new type of asset, or just another asset in the existing ABS category.

According to the ECB’s general documentation, it seems that the Eurosystem could already buy these assets if they respected general requisites, including sufficient rating. While this kind of purchases would have a strong effect in the periphery, and especially in Italy, in aggregate terms its effect would be limited.

Finally, in theory, the ECB could purchase foreign assets, for example US Treasuries. But this would be contrary to G7 and G20 commitments and would be seen as the declaration of a currency war.

This means that there is limited scope for adding assets to ECB purchases. Adding some equity and corporate bonds could, however, be done.

Markets expect the ECB to further lower interest rates, as shown by the fact that overnight indexed swap (OIS) rates for maturities longer than 2 months are already lower than the current deposit rate at -30 basis points. What is less clear are the modalities and the amount of the cut.

As regards the modalities, it is likely that the ECB will have recourse to a tiering system for negative rates, like the Bank of Japan, the Swiss National Bank and Danmarks National Bank.

Applying different rates to different tranches of reserves deposited with the central bank, known as ‘tiering’, would reduce the average burden on banks while maintaining the stimulus coming from the lower marginal rate.

It should be recalled here that, in a way, the ECB already applies tiering to the reserves held with it: compulsory reserves, in fact, are remunerated at the rate of the Main Refinancing Operations, now at 5 basis points, and not at the negative deposit rate.

Indeed the ECB could reduce the average burden of negative interest rates on banks just by increasing required reserves, without modifying the structure of its operational framework. Tiering could also help to avoid excessively penalizing banks in the core of the euro area that hold a disproportionate amount of reserves at the central bank.

Tiering, however, would not help much in reducing the incentive for banks to arbitrage between bank reserves, with a negative return, and currency, with an intrinsic return of zero. This means that tiering would not substantially increase the latitude of central banks to push their rates deeper into the negative domain.

In fact banks will not react to the average cost of the negative interest rates on bank reserves, but to the marginal cost, the most penalising rate. Why would a bank hold the part of its reserves yielding deeply negative rates instead of exchanging it with currency, independently of the average cost of its reserves?

In addition, the effect on bank profits is not the only possible negative consequence of negative interest rates. Interest rates below 0 have hardly occurred for the past 5,000 years, and so we do not know what their effects could be, so central banks will be cautious in progressing into the negative domain.

In assessing the effect of even more negative money market rates it should be recalled that short-term rates are, directly, mostly irrelevant for consumption and investment and thus for demand, economic activity and eventually inflation.

Changes in short-term interest rates by central banks matter as long as they lead to changes along the yield curve/risk curve of interest rates that are more important for households and firms. But with the yield curve as compressed as it is, there is little room left for this kind of indirect effects.

In conclusion, the statement by the ECB’s Governing Council that it has “a broad range of instruments and tools at its disposal” appears to us overly optimistic. Of course, such a bullish statement could be based on insider knowledge that some new, brilliant idea is being devised at the ECB. We will know on March 10th if this is indeed the case.

However, short of a coup de théâtre on the 10th, our view is that the ECB still has a few instruments readily available and that it should use them as effectively as possible in the pursuit of its price stability objective. But it should also be recognized that their effectiveness is likely to be quite limited and associated with significant side effects.

Beyond monetary policy, three major economic policy tools remain. The first one is so-called helicopter money. Helicopter money is in fact a fiscal policy tool, as it is a transfer from an inflation tax to the citizens receiving the “drop”.

Arguably, this tool is outside the mandate of most central banks in the world, and it would certainly evoke major controversy in the case of the ECB, which is not equipped with a centralised fiscal counterpart.

The second tool is outright fiscal policy. Yet, the countries eager to act, like Italy, Portugal, Spain and France, are the ones that should stay on the prudent side of fiscal policies.

Instead, the countries that have room to move, like Germany and the Netherlands, prejudicially refuse to recognise the problem of deficient demand in the euro area and will not even discuss fiscal easing.

In addition, there is little evidence that countries are following the ECB’s advice to change the composition and size of public revenue and expenses without changing the fiscal balances to make the budget more growth friendly.

A third tool is structural policy. The Chinese G20 presidency has emphasized the need to forcefully address structural weaknesses in all economies.

In China, overcapacities and the low consumption share point to the need for major structural reform. The euro area, in turn, has moved slowly on meaningful reforms. Even countries under severe financial stress have often only half-heartedly endorsed reforms, while major countries in the core of the euro area have barely reformed in the last 5 years.

Joint initiatives such as single energy and digital markets are progressing slowly, and uncertainty over the EU’s climate policy remains high. What is missing is a strong program of measures with a relatively quick impact on growth, such as major reforms in the energy market and single digital market or the implementation of a single market for services.

Indeed, within the nearly infinite number of conceivable structural measures, IMF analysis has identified those that have a growth pay-out in terms of quarters rather than years and a programme coordinated at the euro-area level could bring significant growth and, eventually, price stability gains in the longer term.

Finally, deeper structural reforms would fundamentally alter the resilience and growth performance of our economies. Policymakers must diversify the financial system towards a greater role of capital markets, and address rising inequality. Progress in these areas is, in the best case, uncertain so far.

Written By: BRUEGEL