They Came To Play

by: Michael Ashton

I am generally reluctant to call anything a "game changer," because in a complex global economy with intricately interdependent markets it takes something truly special to change everything. However, I am tempted to attach that appellation to the ECB's historic action this morning. It probably does not "change the game" per se, but it is very significant.

Feeble money growth in the Eurozone has been a big concern of mine for a while (and I mentioned it as recently as Monday). In our Quarterly Inflation Outlook back in February, we wrote:

The new best candidate for having a lost decade, now, becomes Europe, as it sports the lowest M2 growth among major economic blocs… It frankly is shocking to us that money supply growth has been so weak and the central bank so lethargic towards this fact even with Draghi at the controls. It was generally thought that Draghi's election posed a great risk to price stability in Europe… but in the other direction from what the Eurozone is now confronting. There have been murmurings about the possibility of the ECB instituting negative deposit rates and other aggressive stimulations of the money supply, but in the meantime money growth is slipping to well below where it needs to be to stabilize prices. Europe, in our view, is the biggest counterweight to global inflationary dynamics, which is good for the world but bad for Europe.

All of that changed, in one fell swoop, Thursday. The ECB's actions were unprecedented, and largely unexpected. First, and somewhat expected, was the body's decision to implement a negative deposit rate for bank reserves held at the ECB. This is akin to the Fed incorporating a negative rate for Interest on Excess Reserves (IOER). What it does is actually penalize banks for holding excess reserves.

There are two ways for a bank to shed excess reserves. The first way is to sell the reserves to another bank in the interbank market. This doesn't change anything about the aggregate amount of excess reserves; it just moves those reserves around. In the process, it will push market interest rates negative (since a bank should be willing to take any interest rate that is less negative than what the ECB is charging) and probably increase retail banking fees at the margin (since there is otherwise no way to charge depositors a negative rate). This will weaken banks, but doesn't increase money growth. The second way a bank can shed excess reserves is to lend money, which increases the reserves it is required to hold and therefore changes the reserves from excess to required. A bank is incentivized to make marginally riskier loans (which lowers its margins due to increased credit losses) because there is a small advantage to using up "expensive" reserves. This also will weaken banks. But, more importantly, it will stimulate money growth and that is what the ECB is aiming for.

If that was all the ECB had done, though, it would not be terribly significant. The utilization of the ECB's deposit facility is only about €29 bln at this writing, which is already near the lowest level since the crisis began (see chart, source Bloomberg).

But the ECB did not stop there. At the press conference after the formal announcement, Draghi unveiled a package of €400 bln in "targeted" LTRO, which means that if banks lend the money they acquire through the LTRO then the term of the loan is four years; otherwise it must be paid back in two years. Even more important, the central bank suspended the sterilization of LTRO. "Sterilization" is when the bank soaks up the reserves created by the LTRO. As long as the ECB was sterilizing its quantitative easing, it could not have any impact. It is similar, but more extreme, to what the Fed did in instituting IOER to restrain banks from actually using the reserves created by QE. It never made much sense, but in the ECB's case there was evidently some concern that doing QE without sterilization was not permitted under the institution's charter.

Apparently, those concerns have been resolved. But QE without sterilization is meaningful. The ECB is thus not only doing quantitative easing, but is actively taking steps to make sure that the liquidity being added to the system is flushed, rather than leaked, into the transactional money supply.

If the ECB actually follows through on these pledges, then we can expect a rapid turn-around in the region's money growth, and before long a turn higher in the region's inflation readings. And, perhaps, not merely for the region: the chart below (source: Bloomberg, Enduring Investments) shows the correlation between core CPI in the US and the average increase in US and Eurozone M2. Currently US M2 is growing at better than 7% over the last year, while Eurozone M2 is 1.9%. Increasing the pace of M2 growth in Europe might well help push US inflation higher - not that it needed any help, as it is already swinging higher.

The renewed determination of the ECB to push prices higher should as a result be good not only for European inflation swaps (10-year inflation swaps were up 2-3bps Thursday, but have a long way to go before they are back to normal levels - see chart, source Bloomberg), but also for US inflation swaps (which were up 1-2bps Thursday).

Finally, if it is true that central bank generosity is what has been underpinning global asset markets, an aggressive ECB might give a bit more life to global equities. Perhaps one more leg. But then again, perhaps not - and when the piper's tune is over, it could be brutal. It is currently quite dangerous to be dancing to that piper. For my money, I'd rather be long breakevens.

This is interesting for lots of reasons, but one of them is that the ECB will measure (if I understand correctly) the net lending of the institution, so if that contracts then the loan will be called. But there are lots of reasons for an institution to decrease lending. Some of them, such as a generally weak economic environment or a weak balance sheet of the bank, would be exacerbated by an unwelcome "call" of the loan by the ECB. In the former case it would exacerbate a weak economic situation; in the latter it could accelerate a bank collapse. I may not understand the conditions for the call, but if my understanding is correct then this is a curious wrinkle.

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