There were two noteworthy speeches by European Central Bank Executive Board members on 26th November. The news reports focused on President Mario Draghi’s speech at the European Parliament, which he confirmed that the ECB would likely phase out QE after next month, despite recent economic data had been weaker than expected. Nonetheless, the speech by Peter Praet on the same day is more interesting and deserve more attention.
In his remarks, Praet, taking the same line as Draghi, emphasized that ECB might end the asset purchase program in December. After that, ECB will rely on two tools to maintain monetary accommodation - forward guidance on policy rates as the main instrument and reinvesting the principal payment of securities purchased under the QE as a complementary tool.
Since June this year, the ECB adopted a new and clear forward guidance. It is now expressed in terms of the expectation that key ECB interest rates will remain at their present levels “at least through the summer of 2019 and, in any case, for as long as necessary to ensure the continued sustained convergence of inflation to levels that are below, but close to, 2% over the medium term”.
How does forward guidance works? In general, economists think that there are two reasons why forward guidance may affect interest rate expectations, according to a recent research survey on unconventional monetary policy by Kenneth N. Kuttner of Williams College.
One interpretation is that forward guidance may convey information without implying a commitment, some economists referred to as “Delphic.” There are two possibilities as to the type of information that could be transmitted. One possibility is that an expansionary forward guidance announcement reveals to the private sector proprietary central bank information that the economy is weaker than previously thought, which in turn implies that interest rates are likely to remain low for a longer time.
A second way in which Delphic forward guidance could affect expectations is by communicating information about the central bank policy rule. This channel may be especially important when markets had no clear sense of how economic conditions would affect how long interest rates would remain near zero.
Alternatively, forward guidance would commit the central bank to pursue the time-inconsistent policy of allowing the inflation rate to exceed the central bank's objective for some time. It is referred to as “Odyssean.” A credible commitment to higher inflation in the future would reduce future short-term real interest rates. Odyssean forward guidance is therefore unambiguously expansionary.
ECB, as evidence by Praet's speech, seems to be believers of both Odyssean and Delphic forward guidance.
Praet explained that the "enhanced rate forward guidance is a two-pronged statement." There is the date-based element that interest rates are expected to remain at their present levels “at least through the summer of 2019”. Also, there is a state-contingent element that rates will remain unchanged “in any case for as long as necessary to ensure the continued sustained convergence of inflation to levels that are below, but close to, 2% over the medium term”.
The date-based element is a commitment device to ensure that the stimulus is not weakened by any expectations of a premature rate hike. This is to ensure investors that ECB is committed to a policy plan that can avoid the time-inconsistency problem.
The state-contingent component, in turn, provides that the monetary stance evolves in a data-dependent manner, which is designed to give the market a clearer sense that economic conditions would affect how long interest rates would remain near zero, thus a Delphic communication device. This can maintain ECB's credibility if the economy experiences a dramatic change.
The enhanced rate forward guidance should "provides a strong anchor for policy rate expectations," said Praet. The graph below, taken from Praet's speech, illustrates the "anchoring effect" of the commitment laid out by the enhanced rate guidance. Since June, when extended forward guidance is announced, rate expectations, proxy by the EONIA forwards, aligned immediately to the rate guidance.
Also, ECB ensured investors that they would implement a reinvestment policy of the existing asset holdings, which is used to ensure that the favorable liquidity conditions and exert continued downward pressures on term premia.
Here is another graph Praet provided to explain the importance of the reinvestment policy.
Source: Peter Praet's Speech
The graph shows that if ECB does not reinvest its bond holding, the excess liquidity in the Eurosystem will decline rapidly in the next three years, and return to the pre-crisis level. Ample excess reserves ensure that the overnight interest rate for euro stays close to the floor of the interest rate corridor set by the ECB, and preserve abundant liquidity in the money market for euro over the coming years.
Together, forward guidance and reinvestment policy should be able to simulate the effect of QE. Recall that, at the risk of oversimplification, there are three channels for the QE to stimulate the real economy: 1) signaling about future policy, 2) improvements in financial balance sheets, and 3) portfolio balance effect.
Signaling about future is precisely what forward guidance will be for, so given that ECB has sufficient credibility, they should be able to convince the market that they are committed to maintaining the low rate as stated in the forward guidance.
Improvements in financial balance sheets mean that the asset purchases by the central banks raise banks’ capital ratios by increasing the value of the existing assets on their balance sheets. Besides, the purchases increased the liquidity of the market for the securities. They would have made banks more willing to lend. This is what the reinvestment policy would like to achieve, keeping a high level of liquidity in the money market for the euro, and the market for sovereign bonds for Eurozone countries.
Portfolio balance effect refers to the fact that asset purchases reduce the supply of long-term bonds, therefore lower their yields by narrowing the term premium, which is the higher expected return on long-term bonds relative to what investors would have earned from investing in short-term debt.
The ECB is hoping that forward guidance and reinvestment policy can suppress the term premium as the QE did. The experience in the US seems to suggest that it is possible to achieve.
However, the recent deterioration in the economic performance for European countries might complicate the picture. The slowing economic growth in the eurozone and political drama, like the one happening in Italy, will likely increase the uncertainty about future short rates, hence push the term premium higher.
Is forward guidance enough to counter the possible rising trend of term premium? That is an uncharted territory which we don't have enough historical data to make inference confidently.
In sum, the ECB's plan to stop QE at the year-end and replace it with forward guidance and reinvestment policy should have a desirable result. Nonetheless, the ECB is dealing with a much more challenging economic climate than the Fed did when they stop their asset purchases. Investors should be cautious about the effectiveness of forward guidance in the eurozone from 2019.
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