ECB keeps its powder dry (for now), but what tools are left for central banks who need to ease?

Thursday 22nd October 2015

ECB keeps its powder dry (for now), but what tools are left for central banks who need to ease ?

Ref: "These Are the Fed's Three Weapons If the Economy Falters" Bloomberg Markets, 21/10/15

ECB boss Mario Draghi stuck largely to the script imagined for him by most analysts when he spoke at the finish of the ECB's two-day policy meeting in Malta earlier today. No decision taken yet on further monetary easing, but with concern over growth in emerging markets and sliding commodity values impacting on the Eurozone's own growth and inflation prospects, the ECB will re-evaluate the situation at their December meeting. If the plan of action conformed exactly to expectations, the language was particularly doveish and most are now in little doubt that the ECB will decide at that meeting to provide more stimulus by beefing up its QE bond-buying programme. Initial market reactions? The Euro and Eurozone bond yields lower (and quite sharply, too).

We've often mused over what ammunition is left to central banks if they need to inject more monetary stimulus at a time when interest rates are already at near-zero, and when QE programmes are either already in operation or have been completed. Bloomberg allow themselves to speculate on what the options might be for the US Federal Reserve if they found themselves in that situation. God knows the Fed would be the last people who would want to ease policy, though funny things can happen. But with fingers crossed we'll call it a hypothetical and academic exercise, and hope that it remains so:

1. More forward guidance:-  "The Fed could offer more hints to investors about when it will raise rates and at what speed. If those communications suggest policy makers will raise rates more slowly than investors had previously expected, borrowing costs could decline, which may spur borrowing and spending".

This approach does have the obvious advantage of costing absolutely nothing, but because it would most forcibly affect short-term yields which are already low, the amount of stimulus would be limited. And did anyone spot the other obvious flaw ? The Fed's track record in "forward guidance" in signalling the first rate hike (we're still waiting) has been pretty hopeless so far and the cause for some concern. In that light, the idea that forward guidance could be put forward as a genuine policy tool seems to be ..... well, stretching it more than a bit.

2. More QE:-  "The Fed could buy more bonds in the policy known as quantitative easing".

Without doubt, QE has proved its worth in times of financial crisis. Whether it would be so effective in a more "normal" recession as opposed to a period of turmoil and stress is open to question, especially when long-term yields are already low. Remember that when the Fed started buying bonds in 2008, 10yr T. Notes yielded 3.11%  --  they now yield about 2%. Perhaps more importantly, the first bond-buying programme more than quadrupled the Fed's balance sheet to more than $4.5trn , where it remains with the Fed yet to implement any exit strategy. Imagine the reaction of a Republican-led Congress to the idea of pumping up that balance sheet still further.

3. Negative interest rates:-  "The Fed could lower its main policy rate below zero, something it has never done. The target rate is currently at between zero and 0.25%".

Counter-intuitive it may be but Sweden has experimented with this without the world turning upside down and it does have some things going for it, most probably a weaker dollar for a start. It might also force investors in search of a positive yield to buy assets with longer maturities and therefore push down longer-term rates. And, at the most simple level, it might just encourage more spending.

The trouble with this is that the US financial system is different to anyone else's, and includes thousands of community banks. These institutions rely on depositors to provide the funds that they can offer in loans. If the depositors, understandably loathe to pay to deposit their own money at the bank and pay for the privilege, take their funds elsewhere, who will provide lending capacity? At a time of recession, it would be exacerbating the very problem you're trying to solve.

  

The fact is that all of these options are far from ideal ..... which is why a couple of Fed officials have recently called for a further delay in the first rate rise. The argument goes that it would be better to be too late than too early. If we're too late, they say, we know how to deal with any resulting inflation. But if we're too early, and the economy stalls, what have we got left to kick-start it again?