Last week, the ECB announced a new package of monetary easing measures. It includes a deposit rate cut to -0.5%, resumption of QE at a monthly pace of EUR 20 billion, a two-tier system for banks and easing of the TLTROs conditions. The Governing Council has decided to use all of the available instruments at the same time so the toolkit is comprehensive and will be in force as long as necessary to achieve the ECB’s goal of price stability. Stakes are high since the ECB deployed the uttermost of the monetary policy mechanisms.
The instant measure announced by the ECB is a deposit rate cut by 10 basis points to -0.5%. The market priced in the probability of the rate cut with 100%, so investors were not surprised by this move. To mitigate the pressure on the banking sector, the regulator announced easing the targeted longer-term refinancing operations (TLTRO III) and introduced a new two-tier deposit system. The tiering implies that part of banks' excess liquidity is exempt from the negative deposit rate. Although the decision to introduce the tiering system was widely anticipated, investors were surprised by the generous conditions of the framework. In the current structure, excess liquidity up to six times of the banks' reserve requirements can be exempt from the negative deposit rate and put at a 0% rate with the ECB. An important feature of the introduced measure is that the regulator kept the ability to change the conditions of the tiering open, so the size of the multiplier and the rate on the exempt reserves could change over time. With these measures, the ECB aims to support banks as they are seen as the main transmission mechanism of monetary policy to the real economy through lending.
Additionally, the ECB decided to re-start its asset purchase program (APP), for which the market expectations were reduced in recent weeks by some members of the Governing Council who argued against the necessity of QE. The regulator will buy EUR 20 billion per month starting November 1, which is a relatively low pace given that the market estimations were between EUR 20 and 50 billion. What surprised the markets is the fact that the program is open-ended because its end is not linked to a calendar period, while most forecasts were mentioning QE for a fixed timespan (e.g. one year). More specifically, the ECB is determined to purchase assets as long as they deem it necessary in order to intensify the impact of their policy. Importantly, the specification of the APP has not been changed compared to the previous QE program, thus it includes sovereigns, agencies, corporate bonds, and ABS.
After the initial announcement from the Governing Council, the bond market rallied, notably in periphery debt. The move was largely driven by the expectations of the large scale QE which would drag yield further down. However, the followed press conference by Draghi and the release of details on the package caused a considerable selloff, especially in the front-end of the curve. An important driver is the lavish tiering system which implies that European banks can now invest a significant amount of their free cash at 0% at the ECB instead of buying short-term securities with negative yields.
The introduction of a new round of quantitative easing was a broadly disputed measure, and the market reaction was also mixed. On the one hand, the absence of the APP would have disappointed the markets because QE was widely expected after the dovish tone of Draghi during his recent speeches. On the other hand, the size of the QE is relatively small and the purchase limits on sovereign bonds did not change. As a result, the market does not expect a significant impact on market rates and also sees a limited impact on the real economy. The results are blurred as the QE impact is different for individual countries within the eurozone. The main beneficiaries of easing are periphery countries, since they can take advantage of the ultra-low yields and continue issuing new debt to cover government spending and to refinance outstanding debts. The divergence was clearly seen after the QE announcement, when yields on sovereign bonds of Italy decreased while German yields have increased.
The QE clash
The controversy of the new round of the QE is driven by some of the members of the Governing Council of the ECB, who openly expressed their disagreements with the restart of APP. In the past, some members already indicated their disagreements with the ECB policy, but this time, the debate is extraordinary. Before the meeting, representatives from the central banks of Germany, Netherlands, France, Austria, Estonia and one of the Executive Board members were vocal about their doubts regarding the necessity of the purchase program in the current economic conditions. However, when during the press conference following the announcement of the new package Draghi was asked about the possible disagreements within the ECB, he stated that there was a broad consensus on the decision. The credibility of this statement was questioned the next day, as the central banks' governors from Germany and France - the largest euro zone economies in terms of GDP and population – stated that they opposed the new debt purchases. An unprecedented event followed, with Dutch central banker Klaas Knot publicly issuing a statement arguing that the start of the purchase program is disproportional to the current state of the economy in the euro area. On the one hand, such an open dispute can harm the reputation of the ECB and unveil the uncomfortable disparity between the euro zone countries. On the other hand, open disagreements within the central bank board is a common practice for some central banks. In the US for instance, the members of Federal Open Market Committee (FOMC) regularly comment on the monetary policy in a public manner. What is important for the ECB is to be consistent in its actions and statements because it needs to be trustworthy enough to manage markets' expectations.
The ECB has accompanied its new package with a change in forward guidance, which is an important tool for managing market expectations. The new QE is open-ended and the ECB is committed to continue buying right until it starts raising rates again, which will happen when inflation is in line with the target. Therefore, implicitly the APP is linked to the inflation target. The language regarding achieving the 2% target has strengthened with the comment that the inflation needs not only to converge but to stabilize around the target. This should prevent premature rate hikes and will lengthen the APP to as long as needed.
Notable is how many times Draghi mentioned "side effects" of the monetary policy, something he has never emphasized before. He stated that the ECB is aware of side effects of their policies and monitors them, and that there would be much fewer side effects should a proper mechanism of fiscal policy be in place. Throughout his speech, Draghi stressed many times that monetary policy has done its best to sustain economic growth, and now it is up to governments to enhance the ECB's achievements and to advance further expansion in the euro area.
The ECB has delivered what Draghi was pushing for – an extensive package to support the eurozone economy. His successor Lagarde is expected to hold a strategic review of the policy when she starts, however we believe that she will follow the current path of loose monetary policy supplemented by an urgent call for active fiscal policy.