- ECB has stepped up its rhetoric ahead of next week's meeting.
- There are no good options for it.
- There is much to consider from the Swiss tactics.
There seems to be a stepped effort by ECB officials to talk the euro down. The process began with Draghi last week indicated that the euro has become a more salient factor as it poses a deflationary risk and threatens the fragile economic recovery.
Earlier today, Bundesbank President Weidmann specifically did not rule out quantitative easing but opined that a negative deposit rate might be a better tool to weaken the euro.
Slovakia's central bank governor indicated that the ECB was preparing measures to avoid a deflationary environment, though did not specify the measures. He did indicate he could support QE if necessary.
Net-net there has been little effect from the verbal jousting. Recall earlier this month, when the ECB refrained from taking fresh action, the euro moved above the top of the $1.33-$1.38 trading range that had confined the single currency since last October. It is trading just below $1.38 now, remains above the low of $1.3750 before the weekend and $1.3760 yesterday.
The market does not seem convinced. After being taken in by the OMT, which has not been operationalized, investors need to see real action to be convinced. "Show us the money," they say. At the same time, there is broad recognition of the legal and technical obstacles to the kind of QE adopted by the Federal Reserve, Bank of England and the Bank of Japan.
We suggested that a way to square the circle would be to apply the Swiss strategy. Recall, when the Swiss National Bank wanted to enact a QE operation, it was constrained by the (small) size of its domestic market. Instead, the SNB bought foreign bonds. The ECB is constrained, not by the size of the bond market, but by the interpretation of its legal charter. We argued that ECB can buy foreign bonds, such as US Treasuries.
Former ECB Director Bini Smaghi seemed to be moving in this direction in an editorial in the Financial Times at the end of last year. He recognized that there were no easy solutions for the ECB. He discussed the merits of a negative deposit rate and suggested it could force financial institutions with excess liquidity to export it out of the euro area. He also noted that sterilization of the bonds bought under the SMP plan could cease, or shift to allow the use of foreign currencies.
The ECB can intervene in the foreign exchange market, which is what purchases of foreign bonds would look like, without prior authority for finance ministers. It can do so directly or through the activity of the national central banks. It can fund such an operation with its reserves or through fx swaps and swaps with other central banks.
The only constraint on the ECB appears that it must consistent with its primary objective of price stability. Given the deflationary risks and the persistent strength of the euro, clearly a foreign bond buying program can be justified by the ECB. It would also help address other ECB challenges, which include weak growth in money supply (M3). Excess reserves would likely increase, and this could help stabilize EONIA at lower levels. To the extent that it was successful in pushing the euro down, it could also aid in the recovery of the periphery.
This also seems to be a superior alternative to the potentially disruptive negative deposit rate, which would also likely have unintended, though not unforeseeable consequences, for the money market funds and the wholesale funding of financial institutions. It avoids the legal morass of a conventional QE program. It is likely to be more effective than a token cut in the 25 bp refi rate, or reducing the upper end of the ECB's rate corridor (75 bp lending rate).
This does not mean that the ECB will adopt the Swiss strategy. However, if the market has erred with Draghi is not appreciating the boldness of his actions. Many are too caught up with the controversial OMT, and forget that he cut rates at his first two meetings as ECB President, unwinding Trichet's blunder and offered not one but two long-term repos. He also cut rates last November, choosing not to wait for updated staff forecasts.