When Will the ECB Move on Monetary Stimulus?

The European Central Bank's (ECB) final meeting at which all participating national central bank (NCB) governors get to vote takes place on December 4. In January¹ a new rotational system starts in which only 21 votes will be cast for monetary policy decision—15 NCB governors and 6 members of the ECB Executive Board. Perhaps more significant, it will also be the last fully anonymous ECB meeting, because accounts of its monetary policy discussions are to be published in 2015. Beyond these changes, a new schedule of meetings starts next year, once every six weeks instead of monthly. Hence for three calendar months a year there will be no monetary policy meeting in the euro area, and the governors rotated off will retain their votes on annual ECB monetary policy decisions.²

The Data Influencing the ECB's Monetary Decisions

Most of the attention about the ECB meeting does not concern these historical footnotes, of course. The public will be looking for its decisions on monetary stimulus—and what form such stimulus might take. To understand the ECB's thinking, one must look at the latest data.

The ECB is far from achieving its inflation target of close to—but below—2 percent over the medium term. Recent data indicate price increases dropped to an estimated 0.3 percent in November. The case for additional monetary stimulus appears clear from the statement by the ECB president, Mario Draghi, that inflation expectations needed to be raised "as fast as possible."

Various other policy options have been nearly used up. Interest rates are as low as they can go, and the ECB's recent Targeted Long-Term Refinancing Operations (TLTROs) of cheap 4-year loans to euro area banks seems to have exhausted its ability to pump additional liquidity into the economy. Early demand in September from euro area banks for TLTRO loans was subdued, though demand could pick up later this month. The ECB might further ease the collateral requirements for TLTRO loans, but bank demand is unlikely to materially increase. Thus the ECB is left with only outright asset purchases to inject more monetary stimulus. What type of assets are bought, and how quickly, remains uncertain.

Last month the ECB indicated that, as a result of recent decisions on TLTROs and purchases of covered bank bonds and asset-backed securities (ABS), its balance sheet is expected to return to what it was in early 2012—a €1 trillion expansion, or an average of €40 billion a month over two years. But the ECB balance sheet size has remained stagnant at just over €2 trillion since the summer. Some experts allege that the amount of available private assets for purchase by the ECB in the covered bond and ABS markets is insufficient for the central bank to achieve its €1 trillion balance sheet expansion expectation. But these experts forget that the private sector can endogenously increase the issuance of such assets in the future in response to the ECB's actions. In principle the ECB might reach its purchase targets through just ABS and covered bonds, provided that financial markets respond vigorously and member states agree to a sovereign guarantee for the riskier mezzanine tranches of domestic ABS so that the ECB can buy them too.³ But the ECB is more likely to expand the list of private asset classes in which it intervenes next year, including corporate bonds or even—as ECB Executive Board Member Yves Mersch has indicated—gold, stocks, exchange traded funds (ETFs), or other widely traded private assets.

Would a major balance sheet expansion raise euro area inflation expectations? Following Draghi's speech at Jackson Hole in August, too much has been made of recent declines in the so-called 5-year inflation swaps (i.e., what markets believe 5-year inflation expectations will be in five years). Nonetheless, the euro area may be just one unforeseen adverse economic shock away from a potential deflationary spiral. Ironically, even good news has its perils for those worried about deflation. The recent dramatic declines in energy prices may further depress headline inflation in the euro area, a major energy importer. Even if lower energy prices spur growth over the medium term, the ECB would be forced to increase the tempo of its balance sheet expansion in that scenario. Such an acceleration would probably require the purchase of sovereign bonds. The political costs of doing so might prevent such action, however. Even if the European Court of Justice upholds the legality of the central bank's outright monetary transaction (OMT) program in January, as expected, such purchases will not be popular in many countries, and more lawsuits may follow.

An Added Uncertainty: Greece, Spain, and Portugal

Another confrontation looms between the Greek government and the rest of the euro area next year. Because the government in Athens seems increasingly unlikely to muster enough votes to elect a new president to succeed Karolos Papoulias, early elections are possible.⁴ Syriza—the main leftist opposition party seeking to end large parts of the country's current reform program, lower Greece's primary surpluses, stop privatization programs, and reverse some structural reforms—is leading in the polls. Should it win power in new elections, the euro area will likely refuse most of its political demands, setting the stage for a mini-repeat of the summer of 2012, where the euro area relied on market mayhem to convince Greek voters to vote for a responsible government. Whether or not such a hardball electoral tactic works again, it will complicate decision making for the ECB on sovereign bond purchases. The ECB would hardly want to purchase any Greek government bonds in a period of conflict over Greece. The ECB lacks the option of buying a GDP-weighted basket of all euro area members, and it would not want to determine which countries' bonds would be eligible, politicizing its own role in a most unwelcome way.

Elections also loom later in 2015 in Portugal and Spain, where the governments have implemented substantial austerity and reforms. Voters are certain to question these steps if they believe the ECB could have helped out instead by buying their bonds. Neither government would therefore want the ECB to buy government bonds just before elections.

Confusion over a Legal Mandate

For political and institutional reasons, sovereign bond purchases will likely require a large majority on the ECB's Governing Council, which may not be possible. Draghi is not likely to proceed with a close vote. Unlike the Bank of Japan, which could be influenced by the political mandate of Prime Minister Shinzo Abe, no single political mandate is possible to help support the recent additional monetary stimulus measures (or any other policy) in a soon-to-be 19-member state euro area. A likely North-South split on the Governing Council in any hasty vote would also aggravate political perceptions, especially with ECB meeting minutes becoming public in 2015.

In addition, opponents of sovereign bond purchases might in extremis pursue a "minority protection" provision in the statutes of the European System of Central Banks (ESCB),⁵ according to which some types of ECB decisions are taken on a shareholders-only basis, requiring approval by two thirds of subscribed capital and by half of the shareholding members. In theory, the German Bundesbank would need only the votes of the hawkish Dutch Central Bank and Austrian Central Bank to block sovereign bond purchases. The relevant articles describing the circumstances for such votes do not seem to apply to this situation, however. (They are not related to the "high legal hurdles" for sovereign bond purchases cited by Bundesbank President Jens Weidmann.) But the statutes do reference "exceptional circumstances for specific losses arising from monetary policy operations undertaken for the ESCB," so the possibility cannot be dismissed entirely.

Any such legal sabotage of bond purchases would damage the ECB as an institution by coming across as overtly political. After all, the ongoing purchases of ABS (which unlike sovereign bond purchases are not risk-free) are legally and logically a better candidate for this type of shareholder vote. In the end, a ruling by the European Court of Justice could be needed to decide the matter, guaranteeing lengthy uncertainty about the legality of ECB purchases. Such uncertainty could undermine the benefit of a "doing whatever it takes" signal from an ECB commencement of sovereign bond buys. Were one or more big shareholders to sue on this issue, Draghi would likely resign, and the move would throw the ECB's credibility into doubt.

A lawsuit is extremely unlikely, but its mere potential means that the ECB will likely act only after achieving near unanimity on the Governing Council, slowing the process desired by its activist majority while the hawkish minority opponents on the Governing Council come around, isolating any ideological hold-out opposition from the German Bundesbank.

The Outcome: No Action until Next Year

The ECB is unlikely to launch new stimulus measures except in response to a (downward) revision of its own quarterly economic forecast. The Governing Council does not want to be seen as rejecting the previous work of its own research department, for example, and will wait for an updated forecast before making any major ECB monetary policy changes. A further downward revision of the near-term parts of the ECB's 3-year growth and inflation forecasts could occur later this month. Even so, the ECB's recently announced covered bond and ABS purchase programs, and the pending second "initial 7 percent allowance TLTRO" later in December, makes new measures unlikely for now. Rather, the ECB is likely to wait and see the economic effects of its latest measures in early 2015.

Assuming that March 2015 will bring small but no further material revisions of the ECB's own forecasts, and that the ECB cannot reach its own balance sheet expectation by relying on existing tools, the ECB will likely broaden the scope of its private asset purchases at that time. Such an expansion will likely include at least corporate bonds and other private asset classes, exhausting available options for further acceleration of such purchases. In line with the possibility of only moving according to the desired pace of its least activist members, only a step-by-step expansion of asset purchases by the ECB seems possible. A direct jump also into sovereign purchases in March 2015 would require a further—and unlikely—material deterioration of the economic and inflation outlook.

June 2015 is the likely date for when the ECB would be truly left with no further stimulus options, other than the purchase of euro area sovereign bonds, to raise regional inflation and inflation expectations. If the ECB's economic and inflation forecasts have not stabilized by then, implying that outright deflation would be imminent, the purchase of sovereign bonds seems likely to commence with overwhelming support on the Governing Council. On the other hand, another six months of downward economic and inflation forecast revisions in the euro area is not likely, which should rule out that the purchase of sovereign bonds by the ECB is a baseline scenario today.

If the ECB does end up buying sovereign bonds, Europeans should thank (or blame) the Saudi oil minister for a huge positive economic shock that delivers "good deflation" to the euro area, though regrettably at an inopportune time. They should also lament the inability of their own inflexible and unreformed economies to take advantage of this gift to grow faster.