While eurozone bond yields hit new lows, action is hampered because of, well..
Fault lines within the ECB
The simmering row between the European Central Bank president Mario Draghi and the German Bundesbank president Jens Weidmann is sometimes painted in personal terms, but in fact it epitomises a wider difference between the hawks and the doves on the ECB governing council. It is important to understand the anatomy of this dispute as the central bank prepares for its next critical meeting on December 4.
The dispute is fundamental and longstanding. Mr Draghi has adopted the New Keynesian approach that dominates US academia and central banking. There is really no difference between the philosophy that underpins his latest speech and that of Ben Bernanke, vintage 2011-13. In contrast, recent remarks by representative hawks such as Mr Weidmann and ECB executive board member Yves Mersch stem directly from the Austrian school of European economics. It is no wonder that these differences are so difficult to bridge.
To start with a point of agreement, both sides accept that the ECB is failing to hit its inflation objective, and both admit that this is a serious issue. However, there is a major difference in the urgency attached to this. Mr Draghi says that inflation must be raised “as fast as possible” because “the firm anchoring of inflation expectations is critical under any circumstances”.
In contrast, Mr Weidmann says that “a problematic wage-price spiral is still a remote prospect”, and adds that “monetary policy matters should be considered with a degree of calm”. That is presumably why the Bundesbank president voted against the monetary easing announced by the ECB in September, though he did support the consideration of further unconventional measures, as announced by the GC in November.
On the content of these measures, there seems to be an even wider gulf between the two sides. This starts with the size of the ECB balance sheet. Mr Draghi says that both the composition and the size matter. He explains that “the magnitude of portfolio balance effects is a function of the size of the central bank’s balance sheet … the greater the purchases, the greater the displacement across asset classes”. He also points to the beneficial “announcement effects” on inflation expectations and the exchange rate, which explain why he is seeking to give the impression that the ECB has a specific target of returning its balance sheet to its size as of March 2012. All this is pure Ben Bernanke.
The GC has, however, prevented its president from formally adopting the balance sheet number as a “target”. It is merely an “expectation”, as Mr Weidmann is reported to have pointedly commented the day after the last ECB meeting. Furthermore, Mr Mersch adds that the size of the balance sheet is “neither an end in itself nor a fetish”. Instead, he describes the recent ECB measures as merely “credit easing”, designed to improve the efficiency of the bank’s credit channel. That is very different from Mr Draghi’s emphasis on the announcement effects of the size of the balance sheet.
On the prospects for further measures, Mr Draghi says that if current policy is “not effective enough” then the ECB will “alter accordingly the size, pace and composition of our purchases”. Mr Mersch concedes that the GC has unanimously agreed that more could be done if needed, and says that “theoretically” this could include purchases of “government bonds, gold, stocks and ETFs”. The mention of gold has raised some eyebrows among macro investors, but it is hard to believe this is a serious suggestion.
Much more important is the mention of government bonds. This is where both Mr Weidmann and (probably) Mr Mersch draw the line. Both say, as usual, that this risks “moral hazard”, reducing the incentive for governments to achieve debt sustainability and pursue structural reforms. Both also say that it is “questionable from a legal point of view”. This directly conflicts with Mr Draghi’s repeated claims earlier this year that the GC was unanimous in its opinion that sovereign debt purchases fall within the ECB’s mandate.
Mr Mersch has analysed government bond purchases in some detail, saying that they could have beneficial portfolio balance effects by lowering bond yields. But he warns that these are not very important in the euro area because of the dominance of the banking channel, rather than the bond market, in corporate lending. He also warns that allowing fiscal interests to dominate the central bank’s thinking could force the latter to allow inflation to rise in order to hold interest rates down.
In his latest speech, Mr Draghi adopts a simple strategy in responding to these points: he does not mention them at all. His silence on this matter is deafening. Instead, he focuses all his rhetorical firepower on the size of the balance sheet, agreeing that “there are certainly question marks as to how strong these effects are in the euro area”, but then concluding “there is no question as to the sign of the effects – it is clearly positive”.
Where does this leave the ECB?
- The ECB president has now, in effect, publicly stated that the unhinging of inflation expectations needs to be corrected urgently. The hawks, however, do not see this as being so urgent.
- Mr Draghi believes it is important to have a balance sheet target, while the hawks reckon that a much softer “expectation” is enough.
- The president probably thinks that in order to persuade the markets that the balance sheet will increase rapidly, purchases should be widened to include other private assets, like corporate bonds and government bonds if necessary. The hawks believe that any assets purchased must involve no credit risk for the balance sheet, and think that government bond purchases involve both credit risk and moral hazard, as well as being ineffective.
It will be an interesting meeting next week. Now that Mr Draghi has nailed his colours to the “urgency” mast, a complete absence of new action would be a serious defeat for him. Purchases of corporate bonds, along with a shift from a balance sheet “expectation” to something closer to a “target” (maybe a “reference value&rdquo
would be a typical ECB tactic.
It seems unlikely that purchases of sovereign debt will be announced next week. This will need to wait until the decision of the European Court of Justice early next yearon the legality of such purchases. It may also need Mr Draghi to call on the tacit or public support of Chancellor Angela Merkel – assuming, as he recently hinted, that he has this in his back pocket for emergencies.