- QE by the ECB has been dismissed due to the impossibility to buy member states' sovereign bonds.
- Yet, the ECB could opt for foreign exchange intervention.
- It would thus weaken the euro and expand its balance sheet at the same time.
The ECB is yearning to go for QE but either does not know how or is not allowed to. As the OMT ruling by the German Constitutional Court shows, bond purchases are considered to lead to redistribution among member states and circumvent the interdiction to buy government bonds directly: interference with fiscal discipline, distortion of credit risk premia, potential monetary financing. By implementing OMT, the ECB would, according to Karlsruhe, go well beyond its institutional responsibilities.
There will always be a long debate on whether buying member states' sovereign bonds is part of the eligible tools to fulfill the ECB's monetary policy mandate (no discrimination principle). But in absence of eurobonds, the issue of redistribution would always exist - even though the purchase of bonds on the secondary market is definitively part of a Central Bank's tool kit. But as the rise of the EUR/USD continues to threaten the growth/inflation mix and as the marginal impact of verbal intervention is dwindling (not to mention the growing cacophony on the set of available-but-never-used tools), there might be another option available to the ECB: buying foreign sovereign bonds. In other words, it would mean doing QE with non-sterilized forex interventions.
According to my calculations, a 10% rise in the EUR/USD leads to a 0.3 decline in the CPI growth rate (inflation). To reflate the economy and try to gain support from the (slow) recovery in global growth, the ECB might be tempted to weaken the currency with other tools than a European-Style forward guidance (as can be seen below, the relative flatness of the Euribor curve against the Eurodollar curve did not bring the EUR/USD much lower).
In its short history, the ECB has barely intervened in FX markets and the few times it did it were dedicated to support, not weaken the euro. Those operations were short-lived and sterilized - that is, balance sheet neutral. To be effective and more QE-like, any FX intervention should not be sterilized (the empirical literature shows that sterilized FX interventions are useless).
Contrary to the BOJ whose aggressive domestic sovereign bond purchases have dealt a blow on the JPY, the ECB would buy foreign (U.S. Treasuries, JGBs, etc.) bonds, which would translate into an expansion of its balance sheet. The chart below shows the Japan/Abenomics experience: The link between relative balance sheets (Fed vs. BOJ) and the USD/USD remains solid and the future price action for the USD/JPY seems pretty obvious from this perspective.
In Europe, the link between relative central bank balance sheet (ECB vs. Fed) and the EUR/USD has broken down, otherwise the EUR/USD would be close to 1.50. The "relative weakness" of the pair can be explained by the different set of communication tools that have been used by the ECB so far: forward guidance, threat of negative deposit interest rates, mentions of a funding for lending scheme (ABS program), "ready-to-act" posture, etc. However, their marginal utility is decreasing.
Here I explore what an ECB-driven QE may look like: I assume that the central banks manage to bring the EUR/USD back to 1.25 at year-end. If the chart is right, the size of the balance sheet would have to increase by 125% - a rise that would be twice the post-VLTRO increase (+63%)! As a reference point, the BOJ balance sheet as increased 55% since the implementation of Abenomics.
Of course, those calculation are completely biased as they do not take into account the market reaction and whether the move by the ECB would be considered credible or not. Nor does it take into account the structural factors behind the strength of the EUR, among which the size of the current account ( 2.2% of GDP). But it shows:
- That the only possibility for a ECB QE is through FX intervention; and
- The sharp increase in the ECB's balance sheet that would be required.
Next week's CPI data for the eurozone will be of utmost importance since they will be closely followed by the April 3 ECB meeting. There is no chance that the ECB may announce any kind of FX-intervention-driven QE. It is more likely that further liquidity will be injected (once excess liquidity is less than EUR 100bn) rather than a pure QE (which is highly unlikely in the absence of deflation). Setting negative rates is still seen as a fifty-fifty probability, with recent statements by ECB members (J. Weidmann and E. Liikanen) bringing the focus back to this option. But if you think QE is a likely option for the ECB, focus on foreign, not domestic sovereign bonds.