The ECB plans to ease, but how?

The European Central Bank is nervous. Inflation in the euro area has fallen to 0.5 percent (see chart), well below the ECB’s objective of slightly below 2 percent. Not only that, but most of the peripheral countries (including Cyprus, Greece, Slovakia. Spain, and Portugal) are now experiencing deflation. What to do?

Last week, President Mario Draghi signaled that the ECB Governing Council is likely to ease policy at its June 5 meeting. How? Well, unless they peg the euro to the dollar (importing U.S. financial conditions and inflation expectations), we see three possibilities. The ECB could extend forward guidance in an effort to lower expectations about future short-term interest rates; it could buy bonds in a move toward traditional quantitative easing; or it could reduce the interest rate at which banks deposit excess reserves to a level below the current setting of zero. The ECB tried forward guidance first in July 2013 and again two months ago, but with limited impact; QE is difficult to implement; leaving the third option of lowering the deposit rate. Negative deposit rates are the path of least resistance, but the zero lower bound (ZLB) for nominal interest rates severely limits this tool.

Euro Area HICP
(percentage change from previous year, monthly)

Notes: Solid red line is the official euro-area GDP-weighted average HICP. Dashed lines are the minimum and maximum inflation among individual euro-area countries in each month. The country varies. Source: Eurostat.

To understand our conclusion, let’s take a brief look at a few details, starting with quantitative easing. How big would an asset purchase program have to be to have a meaningful economic impact? Very large indeed.

It is hard to escape the conclusion that the ECB would need to find a way to add at least €1 trillion to its €2.2 trillion balance sheet.  Even then, as one analysis of Fed asset purchases argues, the impact of QE would depend on what they purchase, on the signal about future interest rate policy, and on prevailing economic conditions. In a range of likely scenarios, it will be modest.

But there are significant mechanical obstacles to QE implementation in the euro area. As we explained in an earlier post, the likely repayment of up to €650 billion in refinancing means that an even larger gross bond purchase program (€1 to €1.5 trillion) would be needed to achieve the desired net impact. How could the ECB do this? Would they purchase only government issues?  If so, which ones and in what proportion?  Regardless, critics would almost certainly view ECB ownership of, say, 15% of outstanding euro-area government debt as a form of forbidden monetary financing.

What about privately issued debt? Each day, the ECB updates its list of collateral eligible for refinancing. The list currently includes 37,414 separate items. It may be possible to buy over €1 trillion worth of these, but most of them are probably illiquid, so it is unclear how the ECB would select its portfolio and what price it would pay.

Even if acceptable solutions can be found to these operational problems, the actions that would be most effective in easing financial conditions in the peripheral countries (namely, the purchase of illiquid instruments in their markets) would probably be the most likely to cause discord on the Governing Council.

This leaves the move to a negative deposit rate as the most likely policy on June 5. The ECB could begin charging banks for the excess reserves that they keep on deposit. The world has little experience with subzero nominal interest rates. In addition to the 1930s episode in the United States, there are only a handful of recent cases. Over the last few years, the central banks of Sweden and Denmark have both set deposit rates slightly below zero. And market yields on short-term German government debt hit a minimum of –0.10% a few years ago.

So, perhaps the ECB could lower its deposit rate by as much as 25 basis points to -0.25%. However, doing so could prompt cash hoarding. If banks were to maintain their current level of deposits (€40 billion) that would mean paying €75 million per year for the privilege. For that, it is worth renting or building a fair amount of vault space. (Because euro notes are only 0.11mm thick, €40 billion worth of €500 notes could fit in a cube 5 meters on a side, so you wouldn’t even need much steel and concrete.) A larger breach of the ZLB would require an unprecedented change of the monetary regime that is not on the ECB’s (or any other major central bank’s) policy agenda.

More to the point, would conventional QE or negative deposit rates help the euro-area economy materially? Absent a sizable euro depreciation, we doubt it. The euro area’s fragmented financial system suggests that QE will be less effective than elsewhere, while the potential for lowering the deposit rate is tiny. Targeting asset purchases in peripheral Europe would be more effective, but also more controversial (and will diminish incentives for structural reform).

If the ECB is serious about raising inflation expectations and returning inflation to its target over the medium term, a weaker euro appears to be the simplest, most effective route (as one of us previously hinted), but the value of the euro itself is neither a current nor a likely future objective of ECB policy.