The ECB Throws down the Gauntlet
The European Central Bank (ECB) surprised financial markets on September 4 by announcing an interest rate cut of 10 basis points, a new program to purchase asset-backed securities (ABS) in the nonfinancial sector, and another round of purchases of covered bank bonds. The ECB was responding not only to the recent deterioration in the European economy and falling inflation but also to European governments.
The new measures are stronger versions of the ECB's actions in June. The main interest rates are now at just 0.05 percent, and the deposit rate is at negative 0.20 percent. Mario Draghi, the ECB president, said the central bank's interest rates are at rock bottom and will not be cut further, signaling to euro area banks that they should make full use of the ECB's upcoming 4-year Targeted Long-Term Refinancing Operations (TLTROs) now and not wait for lower rates in the future. The ECB Governing Council also hopes that its latest measures will put further downward pressure on the euro exchange rate.
The ABS purchase program (ABSPP) had been preannounced in June but has now been given a new starting time in October with a potential expansion of the pool of eligible collateral.1 By adding on a third round of covered bond purchases, the ECB also expanded the pool of private assets they intend to purchase to include nonfinancial sector assets (mortgages, auto loans, leasing receivables, consumer finance loans, and credit card receivables backing ABS) and bank bonds. Draghi also made it clear that the ECB would buy only the senior tranches of ABS and would consider purchases of riskier mezzanine tranches "only if there is a guarantee." As noted earlier by ECB executive board member Benoît Coeuré, the ECB will only begin taking on real credit risk if there are fiscal guarantees from European governments. This suggests that the ABSPP structure is designed to replicate the earlier Federal Reserve Term Asset-Backed Securities Loan Facility (TALF) program launched in 2008.2
Draghi did not specify the size of the asset purchase programs, but it appears likely to be hundreds of billions of euros. He said the Governing Council intended to expand the central bank's balance sheet to "the dimensions it used to have at the beginning of 2012," or roughly €3 trillion from the current level of €2 trillion. With €450 billion to €850 billion from the new TLTROs, and the new ABSPP and bond purchase program of €150 billion to €550 billion, outright private asset purchases are likely to exceed ECB purchases of covered bank bonds and sovereign bonds under the securities market program (SMP) program in 2012.3
Article 18 in the protocol to the EU Treaty entitles the ECB to buy any private asset in financial markets . In principle the ECB could thus expand private asset purchases even further. But the demand for a fiscal guarantee from governments to purchase mezzanine tranches of ABS suggests a reluctance to take too much private credit onto its balance sheet. The ECB would thus appear to be at the end of the road of these instruments, the only monetary stimulus option left being purchases of a broad portfolio of euro area sovereign bonds.
What are the prospects for further actions by the ECB? Draghi made clear that the latest decisions were not unanimous. Some Governing Council members wanted to do even more and others less. But the statement also emphasized the ECB's intent to fulfill its inflation mandate, suggesting that sovereign bond purchases could occur as a last resort—for example, in the event of another external shock beyond the already negative impact from the Ukraine crisis.
In Jackson Hole last month, Draghi spoke of the need for monetary policy, fiscal policy, and structural reforms to restore growth to avoid Japanese-style stagnation in Europe. Obviously the ECB controls only the former, while euro area governments are responsible for fiscal policy and structural reform agendas. At his press conference, Draghi stressed that there was "no grand bargain" in which monetary stimulus would be return for more fiscal stimulus and structural reforms. But that is what he would have to say. The head of an unelected, independent technocratic institution like the ECB cannot be seen as pressing the elected leaders of euro area governments. Yet, that is precisely what is going on here, very much like the situation in mid-2011, when the ECB laid down a lengthy list of reforms for Spain and Italy were they to be eligible for SMP purchases.
At a time when financial markets are no longer putting pressure on reform-shy European leaders, it is not as easy for Draghi to threaten a denial of financial support to European governments, as his predecessor did in 2011. Instead he is reduced to threatening Germany (and others) with controversial sovereign bond purchases if governments do not deliver on both reforms and fiscal stimulus. Berlin still holds the key to how much fiscal stimulus is possible in the euro area. The ECB's latest measures cannot succeed without separate European action in these areas. In effect, Draghi is saying to Chancellor Angela Merkel that unless Germany does more on fiscal and structural adjustments, the ECB will be forced to do something that neither Germany nor the ECB wants.
How credible is that threat? If no flexibility on tight national fiscal targets is not forthcoming, most Governing Council members may have no choice but to undertake sovereign bond purchases next year. Sovereign bonds purchases by the ECB remain a very small probability, however, for several reasons.
Recalling that the German economy has already taken a confidence hit from the crisis in Ukraine and is thus not as strong as often perceived, the German government is likely more malleable to the idea of some kind of fiscal stimulus than their rhetoric suggests. The key for Berlin is not necessarily concerns over what the ECB might otherwise do—though this might become another major headache now after this week's ECB announcements—but as always concerns over the lack of structural reforms in especially France and Italy. Merkel is not likely, though, to budge without a commitment to real reform from President François Hollande and Prime Minister Matteo Renzi. Fortunately, signs are favorable that they might at last get started. Hollande, his popularity at rock-bottom, has purged his government of opponents of reforms. Renzi knows that he must deliver on his promises to overhaul the Italian economy and political system or risk a quick end to his honeymoon. No amount of fiscal and monetary stimulus is going to restore business confidence and private investment in France and Italy in the absence of credible structural reforms.
Every actor in Europe therefore has good reasons to act. The ECB just raised the pressure a little more.
1. On the one hand the ECB declared that as of October 1, 2014, full compliance with asset quality reporting requirements is necessary, but on the other hand noted that "the Eurosystem [e.g. ECB and national central banks] may temporarily accept non-compliant auto loan, leasing, consumer finance and credit card ABSs as eligible collateral, on a case-by-case basis and subject to the provision of adequate explanations for the failure to achieve the mandatory score required. For each adequate explanation, the Eurosystem will specify its tolerance stance." This obviously provides a large degree of discretion, with respect to the required reporting standards, and further opens up the possibility that individual national central banks (as parts of the Eurosystem) may adopt different stringency levels.
2. TALF, which began operating in March 2009, was originally authorized to lend up to $200 billion, with the US Treasury's Troubled Asset Relief Program (TARP) providing $20 billion in first-loss credit protection to the central bank.