NN IP: Balancing confidence and caution

Marktausblick

The ECB had to do more as politicians did too little. The bank’s capacity for a more dovish stance is now limited.

21.12.2018 | 12:20 Uhr

The outlook for the global economy can basically be summed up as a tug of war between good fundamentals and rising political risk. In some ways the Eurozone outlook is an extreme example of this juxtaposition. One reason is that the region is having to simultaneously deal with a number of political risks. Unfortunately, this may result in the total impact being greater than the sum of the individual parts.

Brexit, the Italian government and the “gilets jaunes” in France are all expressions of deep social and political rifts resulting from the clash between local voter preferences and an extensive, invasive set of common rules. A large trade surplus also makes the region relatively vulnerable to a slowdown in China and trade risks. Last but not least, the ECB has limited capacity to adopt a more dovish stance in response to downside risks. This scenario sets Europe apart from the other major developed regions. The US is enjoying its fiscal sugar high and the Fed can respond pre-emptively to downside risks. Japan is also sensitive to trade risks but has a high degree of domestic political stability, which makes a pre-emptive combined fiscal and monetary policy response a viable option.

The question of potential central bank impotence is only linked to the ECB’s ability to fight downside risk, as there is no limit to the extent by which policy rates can be raised. However, we do believe reflation is always possible for a central bank that is not constrained by political forces if it dares to be bold enough. In an extreme situation it can, for example, resort to helicopter money, which amounts to financing a fiscal expansion by printing money. The experiences of Weimar Germany and Zimbabwe clearly show that this is dangerous medicine for a normal healthy economy, but it may well be a good remedy for one mired in persistent deflation. The big problem in Europe is that the ECB has to deal with 19 different treasuries. This is also the reason why there is a far stricter legal separation between the central bank and fiscal authorities in Europe than elsewhere.

Unfortunately, that separation is not the only political/legal constraint that applies more to the ECB than to other central banks. Quantitative easing has been very successful in fighting deflation risks as well as financial fragmentation in Europe. The latter means that a borrower with exactly the same set of risk characteristics faces different financing costs in different parts of the region. Of course these two are very much related and the ECB has to a large extent been able to effectively address both these evils by enabling a degree of fiscal risk sharing through the monetary back door. In fact it was forced to do so because politicians failed to live up to their responsibilities.

In 2011-13, national governments made the big mistake of concertedly applying fiscal austerity and delayed the creation of a common fiscal backstop that would have helped weaken the doom loop between national bank and sovereign balance sheets. These were both main causes of the second leg of the EMU recession. If fiscal policymakers had not made these mistakes then core sovereign yields and EMU GDP and inflation figures would probably be higher than they are today and the ECB may well be already following in the Fed’s footsteps on a tightening path.

Alas the reality was different and the ECB was in a sense forced to make up for the mistakes of the region’s politicians. ECB President Mario Draghi also endured severe criticism from some of these same politicians for his attempts to act in accordance with the ECB’s legal mandate to ensure price stability. Going forward, the bank’s ability to deliver stability will depend solely on whether fiscal policymakers become more cooperative. For instance, when the next recession hits, the ECB policy rate may well still only be around 1%, which will greatly limit the room for conventional easing. This will be even more likely if inflation expectations are still a bit shaky and susceptible to a renewed downturn. Such a scenario could bring QE back into the picture, but there is a small problem here. The ECB applies a 33% issuer limit for a good reason: if it holds more than 33% of an entity’s debt, it can have a blocking minority in the event of a vote for debt restructuring. However, the ECB would be legally forced to vote against any haircut because otherwise it would be engaging in the direct monetary financing of governments, which is strictly forbidden.

This makes the hurdle for lifting this 33% limit very high indeed. To lift it, the ECB would need broad-based political support, especially from the core countries. They are unlikely to give it because they strongly feel that a country whose sovereign debt burden is deemed excessive should more or less automatically be forced to default as part of any official assistance program. This is probably not a good idea anyway, as it will only reinforce the tendency towards destabilising capital flows, which nearly killed the whole project in 2012.

The beneficiaries of such flows are core governments, which see their borrowing costs falling into negative territory in real terms. When this happened in 2011-13, they failed to take advantage of the situation. If they had engaged in debt-financed public investment programs, it would have undoubtedly benefited their own countries and the region as a whole. And if they had taken advantage of negative real rates, that would at least have raised equilibrium real rates and made the ECB’s life easier.

The upshot is that during the next downturn the region will desperately need a dose of fiscal easing, which will have to be delivered mostly by the core countries. The ECB’s job would also be made much easier if further steps towards fiscal, banking and capital market union were able to reduce the likelihood of destabilising intra-EMU capital flows. In this context, it makes sense to rely heavily on creating incentives for the private sector to behave in a way that stabilises capital flows, i.e., increased reliance on private sector risk sharing, which is what a banking and capital market union is all about. However, this is unlikely to be sufficient. Even the US economy, where the individual states are far more integrated with each other in real and financial terms, needs a degree of Federal fiscal risk sharing every now and then. Whenever that happens, it is vital that the Federal government can issue a truly risk-free asset (UST). In a downturn, private investors will massively flock into US Treasuries, making it easier for the government to stabilise the economy through debt financed fiscal easing.

The ECB’s back is close to the monetary wall

The upshot of all this is that the ECB is with its back close to the monetary wall. The 33% limit on bond holdings is clearly in sight for a number of countries and flattening the money market curve much further via rate guidance will probably be difficult. Of course this does not mean that the ECB is completely powerless. It could still resort to private QE/credit easing again in a crisis if domestic credit spreads blow out. Private QE has the advantage of being politically less contentious even though some worry that its use may impede efficient risk pricing in credit markets. Furthermore, long-term refinancing operations (LTROs) will remain an important tool and can be very effective in easing bank funding costs. Finally, the monetary wall essentially consists of political constraints and as such can also be broken down in a severe crisis. However, the region is still far removed from this point so it would be wise for investors to regard the monetary wall as the real constraint for the foreseeable future.

An important implication of this monetary wall is that it reduces the strength of the ECB put option as a safeguard in the event of downside risk. In an environment of increased nominal growth, uncertainty, and rates at the effective lower bound, the ECB should ideally act pre-emptively in the face of mounting downside risk. This is exactly what the Fed did in 2015/16. It can therefore be argued that the ECB should have surprised the market by extending QE for another six months or so at the current pace. However, political constraints in the form of the threat of Italian fiscal dominance prevented them from doing so. The only thing the ECB can now do is to reactively marginally adjust its policy levers in response to rising downside risks. But there is also some automatic stabilisation property built into its rate guidance because elements of it are state-dependent.

Whenever the nominal growth outlook worsens, markets automatically act, flattening the EMU money market curve. The new approach in Thursday‘s ECB press conference was to apply these same kind of automatic stabilisation properties to its reinvestment guidance. The ECB will reinvest maturing bonds in full “for an extended period of time past the date when [it] start[s] raising the key ECB interest rates, and in any case for as long as necessary to maintain favourable liquidity conditions and an ample degree of monetary accommodation.” This means the ECB will follow the Fed strategy of first getting rates into positive territory before allowing its bond portfolio to shrink. Having said that, it may well start this process earlier than the Fed did. The Fed explicitly said that rate normalisation had to be “well underway” while the ECB talks about an “extended period” (roughly a year) after the date of rate lift off. This could mean that the refinancing rate is still well below 1% when the ECB starts selling part of its bond portfolio.

The main trick Draghi had to pull out of his hat was to “sell” the end of QE to the markets in a way that would not lead to a tightening of financial conditions. In the past, he has been very successful in putting enough dovish foam on the runway and this time seemed to be no exception. His new mantra – “continuing confidence with increasing caution” – is another way of saying that the balance of risks has shifted to the downside but not enough for the ECB to no longer characterise them as “broadly balanced”. This is stretching things a bit, to put it mildly, but Draghi could not have openly admitted that the risks are to the downside while simultaneously ending QE.

As for the dovish foam, Draghi emphasised that QE is still one of the tools in the box. In other words, it can be restarted if necessary. But, as stated above, it will take a lot to reach this stage and in the near term we only envisage this happening in the case of a severe downturn. Secondly, Draghi went out of his way to praise the market for correctly interpreting the ECB’s rate guidance, and in doing so endorsed recent dovish rate repricing. Thirdly, the ECB once again indicated that it is considering a replacement for the TLTROs to avoid the liquidity cliff facing the banking system.

This is not an easy decision. Any TLTRO will very much favour Italian banks, which could reduce the pressure on the Italian government. There may well be a difference of opinion on this within the Governing Council, with some thinking the ECB should not meddle in an argument between fiscal policymakers but should protect its own backyard (the banks) against the fallout from this conflict. Others, however, may well believe that the ECB should help put pressure on the Italian government to behave responsibly.
 
Another difficulty with the TLTRO is the rate that will be applied to it, especially now that the ECB is starting to rethink the wisdom of negative deposit rates. The bank’s position has always been that while negative rates reduce net interest rate margins for banks, they also allow for faster credit growth, more capital gains and reduced provisions for non-performing loans. But as the related costs are permanent while the benefits decrease over time, there is a significant risk that the ECB will implement a purely technical deposit rate hike in the foreseeable future.

Such a hike should not be interpreted as a signal on monetary policy stance, as it will purely be a measure aimed at improving bank profitability. The problem is that such a distinction is easy to make in theory but in practice, the market may well see a technical deposit rate hike as monetary policy tightening. In that case financial conditions will tighten. Any technical deposit rate hike will probably be accompanied by stronger interest rate forward guidance, possibly by pushing the date dependent part further out into the future. For now we maintain our view that the first rate hike will come in September, but if uncertainty regarding nominal growth has not diminished significantly come March, the risk of the first rate hike being postponed to early 2020 will increase.

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