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The European Central Bank (ECB) is reportedly on the cusp of another round of euro area sovereign bond purchases. Proponents of such a move say it is necessary if the ECB is to grow its balance sheet by the €750 billion to €1 trillion signaled by its president, Mario Draghi, on September 4. Yet it is probably a mistake to expect this action soon.
True, euro area headline inflation has fallen to 0.3 percent , well below the ECB's inflation mandate of close to but below 2 percent in the medium term—and possibly only one external shock away from outright deflation. But that does not mean that the ECB governing council majority is feeling any urgency. Draghi has not provided a timetable for the balance sheet expansion, saying that the new targeted longer-term refinancing operations (TLTROs) will unfold over two years. It will take until December to even begin to gauge its impact on the balance sheet.
The total balance sheet expansion will result from three channels—the new 4-year TLTROs, renewed purchases of covered bonds, and the ECB's new asset-backed securities (ABS) purchase program. With the first TLTRO generating just €82.6 billion in new demand from banks and just over €63 billion in net new demand for long-term ECB loans,1 the ECB faces nearly €350 billion in maturing LTROs in December 2014 and February 2015. The new TLTROs must exceed this tally before generating a net expansion of the ECB balance sheet in the coming months. Indeed, the total scale of the ECB's longer-term refinancing operations and the balance sheet as a whole might actually shrink before early 2015.
But additional lending-benchmarked TLTROs are planned for each quarter from March 2015 to June 2016, offering euro area banks additional access to cheap long-term ECB loans to accommodate their rising loan demands. Aggressive new balance sheet expansion from TLTRO-measures is thus not likely until after early 2015. Thus the net ECB balance sheet expansion in the short-run will come from one of two sources. The first would be renewed purchases of covered bonds, where the program size should bigger than the ECB's two earlier covered bond purchase programs, which were put in place to stabilize specific bond market segments. The total amount of bond purchases amounts to only €45.8 billion.2
Second and more importantly, the balance sheet expansion may come from the ECB's new ABS purchase program, where new details are expected in early October in Naples. But last week Draghi repeated the central bank's intention to buy only the safest top tranches of European ABS, and possibly—if a guarantee is provided—the riskier mezzanine tranches. He also noted that the ECB would only buy the senior tranches that are already eligible for euro system operations. Thus a minimum BBB investment grade rating would needed to be eligible as ECB collateral, thereby likely excluding Greece and Cyprus unless an exception is made for them as some press reports indicate.
A question remains over the nature of the public guarantee required for these mezzanine tranches. Previously during the euro area crisis, the ECB accepted default-rated Greek bank collateral with a multibillion euro sovereign guarantee (collateral enhancement) from the euro area as a whole. Duplicating that feat may be hard because of fears of new losses and potential fiscal transfers to private sector actors by other euro area members.
The ECB might, however, accept a public guarantee from an individual euro area member state created from its domestic assets, the functional equivalent of a national emergency liquidity assistance (ELA) type ABS guarantee. Because of the euro area commitment never to restructure euro area sovereign debt again, even this type of national guarantee would implicitly be backed by both the European Stability Mechanism (ESM) and the ECB itself through a potential sovereign bond purchasing program, or outright monetary transaction (OMT). National guarantees might see the ECB purchasing mezzanine tranches in credit constrained countries in Europe's periphery but not in countries where governments are unwilling to provide guarantees. Accordingly, the ECB might buy disproportionately more ABS in the crisis countries, increasing the program's economic impact.
Purchases of ABS by the ECB will likely lead to an increase in private market creation of such assets. At least that has been the experience of the ECB's collateral program. Concerns about a small available volume of outstanding ABS in the euro area are thus exaggerated. After all, restarting the euro area ABS market is an imperative in the structural transformation of the euro area financial system away from its excessive reliance on bank credit. It would make sense for the ECB to take its time before evaluating the success or failure of the new ABS program.
These factors add up to a likely delay in Frankfurt deciding whether to take additional stimulus measures. But additional reasons are likely to come into play and make sovereign bond purchases unlikely.
First, the Governing Council is reluctant to engage in such politically fraught purchases, if only because there is no guarantee that such a step would work in euro area economies that remain unreformed. In the absence of progress to reduce economic rigidities, there will be no easy way to end bond purchases, and members of the governing council may wish to avoid the risk of starting something they cannot be sure to easily end themselves. After all, the ECB's independence from political interference is total,3 and the definition of "the medium-term" is in the eye of the beholder, so the immediate fallout from undershooting the inflation target is limited.
In addition, the ECB governing council is likely to be more reluctant to undertake sovereign bond purchases early next year because of the beginning of the rotational changes in its voting membership. Several potential proponents will not be eligible to vote in January, including Luis María Linde from Spain, Yannis Stournaras from Greece, and Patrick Honohan from Ireland. A probable "no" voter, Ardo Hansson from Estonia will also not be eligible that month. But in February, Christian Noyer from France, Yannis Stournaras from Greece, Patrick Honohan from Ireland, and Chrystalla Georghadji from Cyprus will not vote, followed by Ignazio Visco from Italy, Yannis Stournaras from Greece and Chrystalla Georghadji from Cyprus in March. A probable "no" voter, Vitas Vasiliauskas from Lithuania will also not be eligible. But all told, it will become harder to gather the 11 votes necessary to launch sovereign bond purchases in the first quarter of 2015.
Other factors militating against early action include the recent substantial decline in the bilateral euro exchange rate versus the US dollar, potentially increasing headline inflation over time, which might make the ECB want to wait. In addition, the ECB's purchases of private ABS will pack more of a punch in new credit private stimulation because of its higher "monetary multiplier" effect (even much larger than sovereign bond purchases), again motivating the ECB to wait and see. The ECB also retains the option to launch new private asset purchase programs, invoking its legal right to purchase any traded private asset it wants. The Governing Council can buy corporate bonds or other private asset classes to further boost its balance sheet, for example, in case the new ABS program disappoints. In such a scenario, the ECB would be choosing to take on more private credit risk while avoiding the political risks of sovereign bond purchases.
Finally, Draghi's call at Jackson Hole for Abenomics-like macroeconomic coordination in the euro area has gone unheeded so far. Prime Minister Matteo Renzi of Italy is finally forcing his center-left party to support labor market reform. But President François Hollande of France still has to deliver any new reforms, without which Berlin will not likely support new fiscal spending. Fiscal policy and structural reforms must go hand in hand if monetary policy is to succeed. Frankfurt may well have to wait for that to happen.
In sum, only a new and unforeseen emergency is likely to persuade the ECB to launch sovereign bond purchases anytime soon.
Notes
1. €19.3 billion of the original 3-year LTROs was repaid in the week when the first 4-year TLTRO was offered, according to the ECB's weekly balance sheet.
2. The ECB's first two covered bond purchase programs were of a combined total scale of €60 billion plus €40 billion, though the ECB ultimately only purchased less than €20 billion in the second program, as the market soon stabilized.
3. Article 7 in the Statutes of the European System of Central Banks reads : "In accordance with Article 130 of the Treaty on the Functioning of the European Union, when exercising the powers and carrying out the tasks and duties conferred upon them by the Treaties and this Statute, neither the ECB, nor a national central bank, nor any member of their decision-making bodies shall seek or take instructions from Union institutions, bodies, offices or agencies, from any government of a Member State or from any other body. The Union institutions, bodies, offices or agencies and the governments of the Member States undertake to respect this principle and not to seek to influence the members of the decision-making bodies of the ECB or of the national central banks in the performance of their tasks."
