25 April 2017
The European Central Bank (ECB) was late to the quantitative easing (QE) party. It purchased EUR 100bn in government bonds under its Securities Market Programme (SMP) during the Eurozone sovereign debt crisis. The central bank also launched two covered bond purchase programmes, amounting to just EUR 15bn in total. However, large scale and broad-based asset purchases aimed at boosting growth and inflation only started in earnest in 2015 – almost seven years after the Fed’s first foray into QE. Since then, the ECB has bought some EUR 1.8tn in assets (see Chart 5) – around 16% of GDP. It estimates that this, and other measures, will add 1.7 percentage points to real GDP between 2016 and 2019. Better late than never.
December’s decision to reduce monthly purchases from EUR 80bn to EUR 60bn was controversial. One interpretation of this step is that it reflected an improving economic outlook. Deflation risks had receded as commodity price disinflation faded, while the recovery appeared to be more entrenched. Another, less benign, interpretation is that the ECB reacted to the prospect of running up against technical constraints to purchases, particularly in government bond markets. The ECB has committed to buy bonds from member states according to the weights from its capital key, limit purchases to 33% of any individual bond and buy no more than 33% of the total of any member state’s debt (including existing SMP holdings). These constraints place limits on the scale of asset purchases. The recent slowdown in purchases has been interpreted in some quarters as a tacit signal from the central bank that it was approaching these limitations. The ECB denies this, and continues to signal a willingness to accelerate purchases if required. However, the scarcity issue is clearly growing as the QE programme matures.
This may be a moot point if the economy continues to recover. Indeed, if the central bank’s forecasts for growth and inflation are achieved, it will likely taper asset purchases in 2018. However, if the economy disappoints, the ECB faces a dilemma. It is difficult to estimate with precision how close the ECB is running to its issue/issuer limits, but these constraints will probably start to bind in 2018 across a number of member states. In this scenario there are a few options. The best response would be a helping hand from governments. Fiscal stimulus would support growth and inflation, while also increasing the issuance of bonds for the ECB to buy. Alternatively, the ECB could break its own rules. It previously refused to buy bonds below the deposit rate, but removed this restriction in January. It could commit to raising the issue/issuer limit, although this would be controversial internally. Instead, it could shift purchase weightings away the capital key. There is some evidence that this is already happening at the margin. For instance, purchases of Portuguese and Irish debt have been running well below the rate implied by the ECB’s capital key over recent months (see Chart 6). A more explicit shift from this weighting would buy more room for stimulus, but again be controversial on the Governing Council. Finally, the ECB could taper purchases, even if economic conditions do not improve. This would provide a blow to the central bank’s credibility and constitute a policy mistake if tightening financial conditions harmed the recovery. The ECB should not stop until it has finished the reflation job.
James McCann, Senior Global Economist