by From: Erwan Mahé 26 October 2017 I had no intention of writing before the ECB meeting today or, for that matter, afterward, given the already abundance of published opinion on the event. However, in light of the varied quality of the studies undertaken so far, I could not resist the temptation to return to my favourite topic, which is the study of the reaction function of central banks, especially, given the particular context faced by the European Central Bank. The only question we need ask today is: What does the ECB’s Governing Council want to do? In reality, that breaks down to two goals. Recalibration is not “tapering” The former involves recalibrating the degree of accommodation (to paraphrase the central bank) in order to take into account the improvement in economic conditions,
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From: Erwan Mahé
26 October 2017
I had no intention of writing before the ECB meeting today or, for that matter, afterward, given the already abundance of published opinion on the event. However, in light of the varied quality of the studies undertaken so far, I could not resist the temptation to return to my favourite topic, which is the study of the reaction function of central banks, especially, given the particular context faced by the European Central Bank. The only question we need ask today is:
What does the ECB’s Governing Council want to do?
In reality, that breaks down to two goals.
Recalibration is not “tapering”
The former involves recalibrating the degree of accommodation (to paraphrase the central bank) in order to take into account the improvement in economic conditions, both locally and globally, and the near disappearance of deflation risk. This goal responds, at once, to its stimulus model and its political constraints, as well as the scarcity of debt instruments eligible for its QE programme. It is worth noting that the latter constraint is self-imposed, with Mario Draghi always holding to the view that the ECB faces no legal limit as to the type of assets it may buy under such a programme, should the need arise. If it were to increase its asset purchases again in response to the emergence of new deflationist risks or the non-compliance of its mandate over too long a time period, there is a good chance that the assets selected to replace the government debt would be financial debt instruments. We could, indeed, imagine an asset purchase programme weighted by the degree of the issuers’ capitalisation (thus, their soundness). The ECB has no better evaluation tool for this sort of matter than the SSM. Said measure would nonetheless benefit the system as a whole whilst favouring the recomposition of the banking sector (pan-European concentration) for which it has been regularly calling.
Avoid, at all costs, a “taper tantrum”
The second, equally important goal is to avoid, at all costs, the repetition in Europe of the taper tantrum of 2013. Ben Bernanke had declared that the Fed was mulling the reduction of purchases of its QE programme, triggering a 100-bps surge in the yield on 10-year US bonds in a few months. In the European context today, such a shock would be fatal to the ongoing economic recovery and would send the timetable for achieving its mandate to the distant future. Any such hike in interest rates might lead to a Risk OFF movement that could exacerbate further the peripheral nation yield speeds, which, in turn, could undermine the credit quality of said countries, laden with heavy debt and low economic growth. So if there is one thing the ECB and Mr Draghi will seek to avoid at all costs, it is a repetition of the economic disruption in Europe of 2010-2012. The lesson to be derived from the taper tantrum, as rigorously argued with the aid of the model elaborated here in recent years, is that the QE programme’s most effective tool is not the amount of excess bank reserves pumped into the system but the signalling effect of the pathway of short-term rates. The ultimate illustration of this phenomenon is the Japanese Yield Curve Control! In 2013 investors initially interpreted Bernanke’s comments as a desire to return to a more neutral monetary policy, which, in their eyes, implied an earlier-than-expected timetable for hiking short-term interest rates, ergo, the immediate impact on long-term rates.
The ECB, which is highly aware of this danger, must strive to differentiate between the recalibration of its degree of quantitative easing and the future pathway of its short-term rates. In short, it is not so much the amount of monthly purchases that will count in the announcement today, but how for how long the programme will be extended.
I would even go as far as saying that the longer the extension, the better, as long as the market is not negatively surprised by a monthly purchase amount of less than €20 billion. Let’s not forget Mr Bernanke’s fantastic paper on the advantages of the Price Level Targeting model, following the Zero Lower Bound policy justifying rock bottom interest rates for much longer than in a normal cyclical context. However, we need to be extremely attentive to all the statements that relate to the Well Past topic. The consensus today appears to be for an extension of the QE until September 2018, and an initial hike in short-term rates (Deposit Facility rate) around March 2019, which would amount to quantifying the term “well past” to about six months. Maybe, but we need to acknowledge that the constructive ambiguity retained by the ECB on this matter, which I consider harmful in the context of Zero Lower Bound, could leave the way open to numerous interpretations.
— To readers who will be present at the press conference today, don’t hesitate to push Mr Draghi to explain himself further on this matter, because it is very important.
Incidentally, the most dovish possible surprise today would be the announcement of a new TLTRO programme! Not only would such a measure remedy the confiscatory (tax) impact of negative short-term rates, it would, above all, have a signalling effect on the future pathway of short-term rates, if entailed granting loans at negative rates for a period of two years. Such a move is not part of my base scenario for today, but I will remain attentive to any clues for the new announcements in December. Above all, we should focus today on the specifics of the “well past”!
Happy reading.
The Macro Geeks’ Corner (MGC)
“Rethinking the Power of Forward Guidance: Lessons from Japan”
Mark Gertler, October 2017
William Vickrey; January 2000
“Money and Banking post 21: The Interest rate”
Eric Tymoigne, October 11, 2017.
“Has the Phillips Curve Gone Dormant?”
FRBSF, Sylvain Leduc and Daniel J. Wilson, October 16, 2017