Ten Measures the ECB Might Adopt to Devalue the Euro at their March Gathering
From cutting the deposit rate to throwing money out of the proverbial "helicopter", we look at ten measures the ECB might adopt at their March get together.
The ECB's March meeting is considered a 'live' event as policy makers will most likely introduce fresh policy to try and halt the euro's recent trend of appreciation while ensuring bank lending to the real economy expands and inflation starts ticking higher to healthier levels.
At the January ECB meeting Mario Draghi said, “there are no technical limits,” to the measures he and his colleagues might introduce to tackle inflation.
Since then he has said, “we will not hesitate to act” if conditions worsen, and most analysts and market commentators now believe some sort of policy response is inevitable.
We ask the question, “what might the ECB actually do at its March meeting?” And list 10 possible monetary policy responses Draghi and his fellow governing council members might introduce.
1. Cut the Deposit Rate
The deposit rate is already at -0.3% - meaning banks and institutions depositing money with the central bank must actually pay the ECB 0.3% interest - but Draghi and the governing council could cut it further, either opting for a further -10 bps cut to -0.4% or -20 bps to -0.5%.
This is the course of action most often forecast by major bank analysts, such as Nick Kounis at ABN Amro and analysts at Bank of America Merrill Lynch.
The thinking behind it is that it targets money sitting in the vaults of the ECB. Actually charging the banks who park their money with the ECB encourages them to spend it instead, thus helping to stimulate economic activity and inflation.
The problem with this course of action is that according to a recent paper commissioned by the EU committee on Economic and Monetary Affairs, entitled “QE infinity: What risks for the ECB?”, it is not particularly effective. In it, author Daniel Gross, argues:
"..the actual impact of any reduction in the deposit rate would be limited by the fact that banks can simply park surplus funds under their required reserves account with the ECB, which does not involve a penalty rate (the interest rate is ‘only’ zero). "
According to the ECB, however, Gross is incorrect and the actual interest rate for money in the required reserve acount is slightly higher at 0.05% (the main refinancing operations rate) - not zero.
In addition, the ECB also point out that banks only enjoy the 0.05% rate on the amount up to the minimum reserve requirement (currently 1.0%) - for anything above that the -0.3% rate applies.
They add further, that negative rates have effectively 'cost' eurozone banks roughly 1.2bn euros since their inception in June 2014:
"So for banks, which are monetary policy counterparties, the cost of depositing funds with the Eurosystem, since the negative DFR was introduced in June 2014, can be estimated to amount to approximately EUR 1.2 billion as of today (split in EUR appr 365 million deposit facility and EUR 825 million CA balance in excess of MRR). However, as indicated before, the negative DFR needs to be seen in context with other ECB monetary policy accommodation measures."
This clearly indicates that negative desposit rates have affected considerable sums of money, and is therefore probably a legitimate monetary policy tool.
2. Increase Purchases
Another option often mentioned by bank analysts is the 10bn increase in the ECB’s monthly asset purchase programme.
At the moment the programme is already 60bn a month, so this would take it up to 70bn.
According to ABN Amro’s Nick Kounis, a deposit rate cut is probably not enough because of the recent, “deterioration in interest rate expectations,” so the ECB might need to increase bond purchases by 10bn instead.
The thinking behind this policy measure, as with all QE, is that the by buying bonds and basically lending the holders money, the ECB is putting more money into the financial system to get to work in a more ‘active’ manner.
Aside from the fact that some economists do not believe QE works (it is way down the list of stimulus measures as measured by impact on growth, and has failed to stimulate inflation in Japan for two decades), in the case of the euro-zone there is the added problem of a lack of supply of bonds to buy.
This explains why, when the ECB lengthened their bond programme to March 2017 at their December meeting, they also increased the number of bonds eleigible for inclusion, to embrace municipal and regional bonds as well.
There is also a legal limit to the amount of bond purchasing the ECB can do before it crosses a line and is accused of “monetising debt”, which has already led to legal challenges, in the case of its OMT scheme, which could resurface with its QE programme.
3. Increase Length
A further option would be to extend the length of the QE programme even further, stretching the APP programme beyond its current end date in March 2017.
In many ways this would be seen as quite ineffective, since it has already been done once at the December ECB meeting when the governing council decided to extend from November 2016 to March 2017.
In addition, because the programme can be wound down at any time if conditions improve, the stipulation of an end-date is not binding in any way and so of little consequence.
4. Change the Law
Transmission of credit from banks to SME’s and households has been seen as a key requirement for a stronger recovery in the euro-zone.
However, the reason bank lending in the Euro-zone has remained so constipated, according to LSE economists Eddie Gerba and Corrado Macchiarelli, is the very high number of ‘Non-performing loans’ (NPLs) on banks’ books, which tie up their capital, which could otherwise be put to work as loans.
In another research paper commissioned by the EU Parliamentary committee on economics and monetary policy, entitled, “Policy options and risks of an extension of the ECB’s quantitative easing programme: An analysis” they explain their thinking:
“..high NPLs tie up bank capital that could otherwise be used to increase lending, leading to a reduction in bank profitability, a rise in funding costs and thus a reduction in credit supply overall.”
The reason for the high number of NPL’s is the specific laws governing lending practices in the Euro-area:
“NPLs remain very persistent in the Euro Area, where the write-off rates for banks remain much lower than for US or Japanese banks.
“According to Aiyar et al. (2015), the reasons for that can be traced back to limited tax deductibility of provisions, weak debt enforcement and ineffective bankruptcy procedures that discourage write-offs and increase the cost of recovering assets provided as collateral for loans.
“Additional reasons are rigid accounting rules that hinder timely loss recognition and a lack of a sizeable market for distressed debt in Europe.”
Clearly, if this analysis is correct then then the above would be the most effective measure for the ECB to implement as it would overcome the problem of limited bank lending, which has been one of the most significant obstacles to the region’s post financial crisis recovery.
5. “Helicopter Money”
Given the problems of ‘transmission of credit’ outlined in option 4 the next obvious recourse would be for the ECB to sidestep banks and lend directly to SME’s and households.
Gerba and Machiarelli, discuss this possibility in their paper, dismissing it eventually, however, as not within the ECB’s mandate:
“It is understood that the most effective way of providing liquidity directly to households and businesses without generating new debt is by giving away “helicopter money”.
“However, since the ECB does not have a mandate to give money away directly to firms and consumers (just exchange one asset for another, in respect of the Treaty on the Functioning of the EU), helicopter money (referred to as money creation to support aggregate demand) need to be backed by fiscal policy decisions (Grenville, 2013).”
The authors further argue that for “Helicopter Money” to be successful it needs to be accompanied by fiscal expansion, however, this might pose problems for countries in the EU who already have high debts:
“QE must be accompanied by fiscal expansion to boost inflation and aggregate demand.
“However, in economies with large public debt, fiscal expansion would worsen the debt burden and thus neutralising the expansionary effects from a fiscal stimulus.
“Therefore, in order for the joint policy to succeed, the central bank should commit to hold permanently the debt purchased, so as to ‘neutralise’ forever the government and taxpayer obligations.”
6. Cut the Lending Rate
It's been done in Sweden where the Riksbank has been the first major central bank to cut the lending rate to -0.5%.
This would be a meatier response to problem of lending than cutting the deposit rate as it would basically involve the ECB paying banks to borrow from it.
The current rate is 0.05%, so a cut to -0.10% would probably be the first move.
The rationale is that this gives banks an added incentive to borrow from the ECB and lend more to the broader economy.
Some have argued it fails to get to the root of the problem, however, which is the failure of transmission from banks down.
One advantage is that it avoids penalising banks via the negative deposit rate, insentivising borrowing instead.
Otherwise, it has a 'wild card' appeal, and is working in Sweden according to Riksbank governor Stefan Nils Magnus Ingves.
7. FX Intervention
Direct intervention involves the ECB directly entering foreign exchange markets to sell and devalue the euro, therefore helping the region's terms of trade, the competitiveness of euro-zone exports and an increase in direct foreign investment.
A complimentary effect is also the boost to inflation from a weaker currency as the value of foreign imports increases, raising prices in the economy and leading to inflation.
8.Change the Criteria or Target
It is possible we have entered a “new normal” in which low inflation has become the norm and the old 2.0% target is not relevant anymore. If this is the case the ECB could simply make the case for lowering the inflation target, to a more achievable level.
Another similar, solution is to change the actual criteria for measuring inflation, including - for example - elements from the RPI which are not “consumer-orientated” in the definition.
On this point, however, Gerba and Machiarelli warn that the ECB could suffer a serious loss of credibility:
“Even in a scenario where the current expectations in the euro area are de-anchored, and settled at a level below 2%, a revision of the ECB’s official target might assist in re-anchoring them, in the light of the weaker economic conjecture.
“Overall, however, this may come at the cost of affecting central bank’s credibility.”
9.Tiered Deposit Rates
This is similar to simply cutting deposit rates, but not as aggressive.
The BOJ has introduced this type of tiered deposit rate measure at its January 2016 rate meeting.
The BOJ system includes three tiers of deposits, which, according to a report in the Seatle Times, were arranged in the following way:
"Existing current account balances will earn a 0.1 percent positive interest rate. Required reserves held at the central bank by financial institutions will earn zero interest. Any additional current account deposits would incur the minus 0.1 percent rate."
J P Morgan Chase, see a tiered deposits as a highly probably policy response from the ECB, saying in a recent report, that:
"Our view is that the ECB will engineer a two-tier system to reduce the cost of negative rates for the banking sector and at the same time will leave enough liquidity at the lower bound."
10. Widen the Eligibility
The ECB has already done this several times: first when it embraced the ‘prodigal son’ of Asset Backed Securities, then Covered Bonds, then Sovereign Bonds and finally in December with its extension into the realm of municipal, city and regional debt.
Other areas which could be plumbed include Equities, Corporate Debt, high-yield bonds and credit from government backed agencies.
