ECB: the currency channel

As widely expected, the ECB has left rates unchanged at today’s meeting and has detailed the two programmes that it will engage into in order to support credit growth.

On the technical details of the programmes, the main challenges as have been reported by several analysts in the international press ahead of the meeting, are both about the size of the ABS market, which collapsed in the euro area since the beginning of the global crisis and is currently worth just about €150bn, and whether the ECB would buy securities from Greece or Cyprus, that have ratings below BBB-. More generally, there were questions about the total size of the programme, i.e., how much would the ECB balance sheet rise.

These questions matter because there is a perception that the ECB has done less than other central banks to fight-off the crisis. Regardless of the merits of that proposition, the fact that the size of the ECB balance sheet has declined by about half since 2012 while those of the Federal Reserve and the Bank of England have almost doubled, may have had a bearing on the strength of the euro until May, that has caused so much pain, particularly among periphery countries that have made sizeable efforts to improve their competitiveness. The strength of the euro has been, up to six months ago, also partly responsible for falling inflation, which is the ECB target.

Over the last six months, the dismal performance of the euro area economy and the ECB’s apparent determination to fight it have led the euro to depreciate by 8% against the dollar. Today’s news should also be supportive of a weaker euro:

  • On the technicalities of the programme, President Draghi has confirmed that the ECB would buy securities from Greece and Cyprus, that are very lowly rated, under similar conditions to those currently applied to the collateral for ECB operations.
  • Draghi has continued to show concern that inflation expectations are low and has, as on previous occasions, implied that there is unanimity in the ECB Council to do more should inflation expectations fail to rise.
  • Finally, Draghi has stated that the total amount of the programme could add-up to 1 trillion euros raising it close to the level of 2012 – though the ABS market is small no doubt it will be revived once the programme is in place.

Still, it is likely that the ECB will remain under attack from several fronts. On the dovish side, particularly financial market participants, there may some disappointment that the ECB has not engaged yet in sovereign bond buying, a much larger and deeper market. At the theoretical level, this view is supported by the idea that the global economy is undergoing an extraordinary period of low, below potential growth and that negative rates and aggressive quantitative easing are necessary in order to steer the economy back to full employment (an excellent book published by Vox EU makes these points in a lot of detail).

On the hawkish front, led by German institutions such as the Ifo and, to some extent, the Bundesbank, the ECB will be criticized for having become a dumpster for junk securities, which represents an unacceptable risk to financial stability in Europe.

The question remains whether the ECB should do more. Part of the ECB problem is that the other central banks have acted very aggressively and it has lagged behind. It is unlikely that it will ever engage in the same scale of asset purchases that the Fed resorted to and led to so much global criticism, because its’ mandate precludes it. However, the ECB could have just as much impact on the markets just because of its timing. By engaging in quantitative easing when everyone else is pulling out of it, the impact on the euro may be significant enough to lead to further declines. If it plays it right, the ECB may avoid having to buy sovereign debt again and support the economy through the exchange rate effect.