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Analysis
Compromises for higher inflation

Compromises for higher inflation

ECB inches towards changed asset purchase rules

by David Marsh

Mon 10 Oct 2016

The European Central Bank is moving closer to raising issuer and issue limits for sovereign and agency bonds acquired under its €80bn-a-month quantitative easing programme, in bid to maintain the momentum of its efforts to raise euro area inflation well into next year.

No decision has been taken. But, in a probable hard-fought compromise on the ECB’s governing council, a continuation of the ECB’s asset purchase beyond the present March 2017 cut-off date seems virtually certain. One principal option under scrutiny in ECB technical committees is to implement an overall €280bn ‘tapering’ programme in the ensuing half-year, allowing the ECB and national central banks to phase out asset purchases by November 2017, shortly after Germany’s parliamentary elections.

In preparing for a possible gradual €10bn-a-month QE wind-down, European central bankers are mounting a campaign to applaud the ECB’s asset purchases since March 2015 for having significantly improved both the growth and inflation outlook.

Yesterday in Washington, Vitor Constancio, ECB vice president, said the ECB’s expansionary policies had brought a respective 0.8 and 0.7 percentage point increase in inflation and growth to the forecast 0.2% and 1.7% this year. The ECB’s official account of its 8 September governing council meeting, released at the end of last week, states that ‘confidence had to be conveyed in the effectiveness of the ECB’s monetary policy measures and the state of the euro area economy, its resilience to global uncertainty and the baseline scenario for growth and inflation.’

The ECB’s technical committees acknowledge that QE extension beyond March 2017 – even in modified or 'tapered' form – would require the ECB to overcome self-imposed hurdles on bond-buying designed to prevent the mechanism from becoming overt monetary financing. Indeed, because of a shortage of eligible bonds under the ECB’s present rules, the feasibility even of already-decided purchases up to next March is viewed as seriously endangered, with scant leeway for increases or extensions unless the rules are changed.

One big problem has been a relative shortage of German bonds, a result of the fall in German yields across much of the maturity spectrum to below minus 0.4%, the ECB’s deposit rate, which at present represents the lower interest rate limit for eligible purchases by the ECB and national central banks.

One issue under review by ECB committees is whether the ECB could change the ‘capital key’ formula under which ECB and NCB buying is in line with the share of euro area countries in the ECB’s equity capital (adjusted to allow for the non-eligibility of Greek bonds under current rules on credit standing).

In fact, in some important ways, the ECB has already been diverging from the capital key approach. According to OMFIF calculations, since April 2016 the ECB has stepped up its purchase of Italian and Spanish government bonds, buying an additional €3.3bn and €2.3bn of Italian and Spanish debt above the amount allowed by the capital key.

Italian and Spanish government bond purchases have exceeded their capital key every month since March 2015 (except for a minor undershoot for Italian purchases in August 2015). The scale of the overshooting has increased since April this year.

A formal change in the ‘capital key’ mechanism, pushing the ECB to purchase more bonds from the highest-indebted countries, has been backed by Italy, as well as Spain, France and some other medium-sized countries, but would run into high-level opposition from Germany and the Netherlands.

A more likely measure would be an enlargement of limits on bond issuers and issues, boosting the asset programme’s potential for extension in size and duration.

Other methods discussed in ECB technical committees include purchasing bonds below the deposit rate (which would harm NCBs’ earnings capacity, and finds only limited favour), spreading unchanged bond-buying volumes over a longer period (supported mainly by the Germans), and widening eligible assets to include equities and non-performing loans. However, these additional options are highly controversial, and unlikely to be enacted. In a governing council decision that will depend partly on the ECB’s forecast for inflation in December, widening issue limits, but phasing out QE by end-2017, seems a strong contender for an eventual compromise.

David Marsh is Managing Director of OMFIF.

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