It’s hard to fully assess at this point the relative importance for the reduction in Irish government bond spreads of the €750 billion bailout fund committed to by the EU and IMF versus the ECB’s decision to purchase sovereign bonds on the secondary market. However, the ECB’s presence or withdrawal from the secondary bond market may prove very important in relation to Ireland’s ability to keep issuing primary debt and staying out of the hands of an EU-IMF deal.
So, three weeks in, what do we know now about this program? A bit more than a few weeks ago but not as much as I’d like. This speech from President Trichet appears to be the most comprehensive discussion of the rationale for the program.
Trichet stresses that this program is being undertaken because it relates directly to the transmission of monetary policy in the Euro area. Some quotes:
We implement monetary policy by setting our key policy rates. Through this, we directly influence short-term interest rates in the money market. Financial markets transmit this impulse along the maturity spectrum, since term rates reflect current and expected future short-term rates as well as risk premia.
These rates, in turn, affect the costs of funding for households, for firms, and for governments. The resulting financing conditions affect economic activity and, in the end, prices.
The functioning of the market for government bonds is central to the transmission of the ECB’s policy rates …..
Because of these channels, severe tensions in the bond market hamper the monetary policy transmission mechanism. The relation between our key interest rates and the rates applicable in the real economy gets out of order, and our main tool for influencing refinancing conditions in the real economy does not work the way it should.
This is the situation that threatened us at the beginning of this month, so we saw the need to act quickly to re-establish a more normal functioning of our monetary policy transmission mechanism. The very rapid consolidation of that situation depends crucially on the effective implementation of the fiscal retrenchment programmes that have been decided in a number of countries.
In terms of the details of the ECB’s bond purchases, some information is released every Tuesday in the ECB’s Weekly Financial Statement. Consistent with Trichet’s characterisation of the program, it is known officially as the Securities Markets Programme (no mention of what type of securities are being purchased) and the purchases under this program are being listed under “Securities held of monetary policy purposes” and not under “General government debt denominated in euro.”
From these reports, we know that the ECB bought €16.3 billion during the week ended May 14, €10.4 billion during the week ended May 21, and €8.8 billion during the week ended May 28. No information has been revealed about the composition of these purchases in relation to whose debt has been purchased or which maturities.
A couple of observations on all this.
I don’t fully agree with Trichet’s characterisation of this program as one that is aimed at ensuring the reasonable functioning of the normal monetary transmission mechanism. That movements in short-term monetary policy rates transmit themselves across the yield curve for risk-free (or almost risk-free) debt is a standard part of the description of how monetary policy works. That other instruments are not seen as risk free and that are movements in the risk spreads on these other instruments is also standard.
The idea that spreads on certain instruments being higher than the central bank would like should prompt an intervention has not, until recently, been a standard monetary policy tool. And risk spreads being high is not usually seen as interfering with the “normal functioning of the monetary policy transmission mechanism.”
What is true, however, is that when monetary policy rates are close to zero central banks can choose to provide extra stimulus by purchasing bonds to reduce spreads on the key instruments. This has been the essence of quantitative easing as practised by the Fed and the ECB, with government bonds and mortgage-backed securities purchased in large quantities to get these rates down. Remember, though, the ECB has another point percentage point to cut should it choose to do so. You can argue that other forces, beyond those that motivated the Bank of England and Fed programs, have intervened here.
Trichet, of course, has been keen to point out that this is “not quantitative easing” because there are also some new operations to take in deposits from banks for a week, so this operation does not increase the stock of high powered money in the Euro area.
I’d disagree with this line of emphasis on a couple of counts.
First, the key aspect of quantitative easing in the UK and US over the past year has been targeted interventions in bond markets to get market interest rates down. This is what the ECB is now doing.
Second, the taking in of deposits under any new program is pretty irrelevant in the grand scheme of things. The ECB are still offering unlimited loans in their refinancing programs, so the sterilisation program is pretty irrelevant for thinking about the determinant of the money supply. And the money supply is far more irrelevant for macroeconomic outcomes than the ECB will admit.
Finally, to the extent that this program differs from quantitative easing as practised in the UK and US, it is that there are extra complications to the ECB program that did not apply in the UK or US and these complications mean that the program lacks transparency and is politically controversial.
Here are things we don’t know about the program:
(a) The composition of the debt securities the ECB is buying.
(b) The criteria being used to select bonds to purchase.
(c) The ECB’s bond purchase strategy during periods of primary issuance.
(d) How long the program is going to last and how much may be spent.
Think about this for a second. Suppose the Fed set up a program to buy municipal bonds but wouldn’t announce how much came from California or Florida or other states or cities. How long would this survive before members of Congress demanded a full explanation of the program? But that’s where we are right now in Euroland.
Of course, part of the reason we don’t have an answer to part (d) above is that there are clearly internal disagreements within the ECB Governing Council on this issue. Trichet conceded in an interview with Le Monde that the decision to undertake the program was not unanimous. He said the decision was taken with “an overwhelming majority”. Well, these are normally a “unanimous decision” kind of crowd so this is an important sign of internal divisions.
Axel Weber and Mario Draghi, heads of the Bundesbank and the Banca d’Italia are already publicly calling for a quick end to the bond purchase program. Draghi pinpoints the moment for withdrawal as when “the markets spontaneously resume trading of the securities of the countries involved.” What Draghi proposes to do if the markets are trading these securities but only because the ECB stays in the secondary markets is unclear. What’s worrying is that there is no clear indication as to how this important program is going to develop over the coming months.