Should the ECB go quantitative?

Many commentators either complain that the European Central Bank has not followed the FED, the Bank of England and the Bank of Japan on the Quantitative Easing (QE) path of purchasing very large amounts of securities or, more kindly, advice the ECB to go that way, to more forcefully fight the risk of too low inflation [1].

Three liquidity scenarios after the year-end.

There are 3 main scenarios that could develop in the liquidity and money market in the €-area at the beginning of 2014, after the tensions at the end of 2013.

First, tensions could dissipate since the reinforced year-end effect has gone.

€ liquidity is getting more valuable: what can be done about it?

It is a recurrent phenomenon that liquidity gets more valuable at the end of the year: this is seen in the fact that, notwithstanding the higher amount outstanding, the overnight money market rate (EONIA) increases in the last weeks of the year. While the phenomenon was suppressed during the crisis by the overabundant liquidity provision, before the crisis, the average increase between the beginning of December and the end of the year, was of the order of 36 basis points, concentrated in the last few days of the month (see table 1). 

Should the European Central Bank do more and go negative?

The European Central Bank is torn between those who say that it is already doing too much, mostly in Germany, and those who say it should do more. One of the actions the ECB should pursue, in the opinion of the latter group, is to bring the deposit rate into negative territory. 

…and what about the other side of the pond?

While on this side of the Atlantic the ECB was reacting more quickly than expected to the much weaker inflation prospects, I was in the US trying to better understand what is happening over there in the monetary area.

On the basis of the talks I had, I came back with a number of thoughts, which were not necessarily shared by my interlocutors but were stimulated by the discussions I had with them.

Forget the € and demand management!

The title of this post is a bit exaggerated, yet it helps stressing the gist of the point I want to make: policy makers, market participants and ordinary citizens should start devoting less attention to the € and to demand management and should concentrate, instead, on supply issues.

Let me expand a little this basic idea.

Don´t supply more when there is no demand!

Over the last few weeks the words uttered by the ECB President, first in front of the European Parliament and then in the latest press conference,  according to which the ECB is: "ready to use all available instruments, including a LTRO (longer-term refinancing operation), to ensure that developments in short-term money market rates are in line with our medium-term assessment of price stability." have attracted a lot of market attention.

Has Bernanke provided a helping hand to Draghi?

In a previous post I stressed the tug of war between the Governing Council of the ECB and the money market: the former has a unanimous intention to keep the monetary policy stance constant or looser, the latter seems well poised to increase interest rates.

In this tug of war, Bernanke has been seen by some as having started to pull on the ECB side with the utterly surprising Federal Open Market Committee (FOMC) decision not to "taper" the 85 billion of monthly purchases of bonds by the FED.

Upward bias vs. downward bias: who will win?

ECB President Draghi confirmed, at the last press conference on September 5th, the unanimous view of the Governing Council: “we wanted to make it clear that we have a downward bias in interest rates for an extended period of time.“ He also said that “The Governing Council confirms that it expects the key ECB interest rates to remain at present or lower levels for an extended period of time. “

“Forward with forward guidance!” OR “Much ado about nothing?

Many central banks in advanced economies have engaged in some form of forward guidance. The latest to tread this path was the Bank of England, which was preceded by the Reserve Bank of New Zealand, the Bank of Japan, the Fed, the Norges Bank, the Sveriges Riksbank, the Czech National Bank, the Bank of Canada and the European Central Bank. Also the Swiss National Bank has lately, if somewhat implicitly, had recourse to forward guidance.

Is the ECB a central bank overburdened with risk?

The short answer is: yes, but not of the kind you think.

The long answer starts by noting that in some quarters the financial risk coming from unconventional monetary policies is advanced as a reason for more caution (or cowardice?). For instance, the Bundesbank in the document on the OMT presented to the German Constitutional Federal Court gave quite some weight to this issue [1].

Cimabue and Giotto, the Bundesbank and the ECB: an analogy?

Cimabue is defined by the Encyclopaedia Britannica as “the last great Italian artist in the Byzantine style”, while in the web-site of the Louvre one reads that Giotto "has been seen down the centuries as the instigator of a painting revolution without precedent since ancient times". Dante Alighieri in his Divina Commedia so defines the relationship between the two painters: “Credette Cimabue ne la pittura tener lo campo, e ora ha Giotto il grido, 
sì che la fama di colui è scura”, which can be translated in English as “Cimabue thought to hold the field in painting, and now Giotto hath the cry.”

Feydeau, Bernanke and Draghi

Georges Feydeau was a master in his theatre pieces to make actors enter and exit doors, as in a ballet, causing great laughter in the audience.

Also Bernanke and Draghi are busy with exits, albeit in opposite directions and causing much less laughter.

Bernanke started communicating to the market that it should not expect the FED to always ease further and that before too long it should slow down and eventually exit from adding to its portfolio of securities. 

Draghi is dancing on the brink of a further rate reduction.

While Bernanke has started his difficult footwork towards the exit, Draghi has engaged in a minuet of his own to signal that the exit is far into the future and that indeed further ease could come. The ranking of the FED and the ECB in terms of monetary policy ease has changed, or at least is changing, with interesting possible consequences for exchange markets. Factor in Kuroda and Carney for some further entertainment coming from central banks in the foreseeable future.