We built this euro system two-geh-tha!! [Ahem, ‘cuse us…]
David Mackie over at JP Morgan has been looking at the ECB’s options this week. What he concludes is that further ECB balance sheet expansion may now be inevitable, and much of the expansion will take place via the ECB funding the ESM, by buying its debt directly.
If you’re wondering how this sort of “monetisation” can be justified (to the Germans)… well, it’s just like Draghi spelled out last week.
The ECB’s accomodative policy has failed to make an impact due to a broken transmission mechanism. Under its own mandates, this leaves the ECB open to the use of unconventional tactics to get it going again. Tactics which.. dah, dah, dah…are allowed to include primary debt purchases if necessary.
As Mackie (and team) explain:
Further monetary policy action from the ECB could be motivated either by a desire to create an even easier overall monetary stance or by a desire to further improve the transmission mechanism. ECB president Draghi has made it clear that the central bank will use all available tools to guard against risks to price stability in both directions. The central bank clearly has some concerns about how large scale asset purchases affect the incentives for adjustment for both sovereigns and banks, especially in a decentralized fiscal and banking system like the Euro area. But, in the event of significant downside risks to price stability, we believe that the ECB would overcome these concerns. Meanwhile, measures to improve the transmission mechanism could be justified at any time given the ongoing impairment.
The impairment of the mechanism, meanwhile, can be observed by the failure of the curve to respond evenly to policy rates decisions.
As Mackie notes, the failure has been quite notable:
In the first decade of EMU, around 60% of the movement in the policy rate was reflected in a movement in longer-term government bond yields. This transmission has not been working since the financial crisis began. If the transmission from the policy rate to longer-term rates had been working in the past three years in line with the experience of the first decade of EMU, then the areawide government bond yield should be around 2.25% currently. In fact, it is 3.20%.
Over at Credit Suisse Jonathan Wilmot has much the same view.
He too interprets Draghi’s comments as a clear signal that the EFSF and later the ESM will buy primary market issues in Spain and Italy soon — and that German protests are not going to make any difference on the matter:
The market impact of this joint fiscal/monetary approach would be strongly enhanced if the Bundesbank drops its opposition to renewal of the SMP program. Talks are scheduled between Draghi and Weidman on this, but we suspect the Bundesbank still questions the effectiveness of the fiscal compact and any conditionality attached to primary market intervention. Still, that opposition seems unlikely to prevent the ECB going ahead, and may be one way of maintaining pressure on Italian and Spanish politicians to keep up their reform efforts.
Unsurprisingly, comments published by the Bundesbank on Wednesday saw Weidmann warning that the ECB should not exceed its own mandate and that it should be mindful of its independence. But the idea that the Bundesbank’s view is now no longer as relevant as it used to be makes things very interesting indeed.
For example, the ECB will now not only be free to monetise away — but to do so in a way that gets the money circulating properly, finally impacting broad money supply. Which, if the following charts from Wilmot are anything to go by, could make all the difference when it comes to boosting nominal GDP:
At least that’s how we read Wilmot’s comment that the ECB crisis has turned for now — but that the “big short fantasy” lives on. Though he promises to explain more on that last point in his next report.
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We hereby declare the below the official theme song to the ECB’s meeting tomorrow:
Although we do have some suggested changes to the lyrics…
Take it to the good times
See it through the bad times
Whatever it takes is what I’m gonna do.
Let the Germans say we’re crazy
What do they know?
Put your arms around me
Merkel don’t ever let the euro system go.
Let the world around us just fall apart
Baby we can make it with large purchases on primary bond markets
And we can rebuild this transmission mechanism together.
Monetary blanks in the Eurozone – FT Alphaville
Negative rates as a precursor to the death of banking – FT Alphaville