"The spirit is willing, but the flesh is weak "...... a potential problem for the ECB.

Wednesday 21st October 2015

 "The spirit is willing, but the flesh is weak "...... a potential problem for the ECB.

Ref : "Draghi May Lack What it Takes to Do Whatever It Takes on Prices". Bloomberg Online

We mentioned yesterday that the European Central Bank's Governing Council meet tomorrow and Thursday in Malta, where further monetary stimulus will be high on the agenda. Mario Draghi and his colleagues have so far made little progress in their efforts to push non-existent headline inflation numbers back up towards the desired level of 2.0%, not helped by modest Eurozone growth and a recently strong Euro (itself deflationary).

If the latest encouraging Bank Lending data means that the ECB is less likely to announce any action at its press conference on Thursday than it was, most remain convinced that they will opt to extend the current 60bn euro per month QE (bond-buying) programme beyond September 2016 sooner or later. An announcement to that effect is most likely in December.

Mr Draghi will always be associated with his 2012 comment about doing "whatever it takes" to save the Euro, and his determination and willingness to act is not in question. There are doubts however over whether even an extension to the existing programme would do the trick. Karen Ward of HSBC for example believes that in order to be effective QE would not only have to be extended but also EXPANDED up to the level of 90bn euros per month....... and that would bring with it severe (insurmountable ?) logistical difficulties.

The biggest obstacle to such a course of action would once again be Germany, though on this occasion not just because it is most sceptical of QE and least likely to be happy with its expansion. The proportions of the ECB's bond purchases are governed by each member's capital stake in the central bank, which in turn is governed by the size of their economies. Thus, German securities account for about a quarter of all bond purchases ..... and that could become a problem. Given Germany's budget surplus, German Bunds are scarce, and are likely to become scarcer.

If the ECB were to ignore its own guidelines and bought proportionately more of one country's debt than another (special bail-out operations excepted), it would be breaking Eurozone rules on monetary financing.

One might be tempted to think that the ECB's move last month to allow themselves to buy up to 33% of any issue (up from 25%) might alleviate the problem. Not so, since it excludes any bond with a "collective action clause" , or CAC (which allows a supermajority of bondholders to restructure the debt). Since Jan 2013, CAC's are mandatory with government issues.

Other constraints to QE expansion would have to include the fact the ECB is not permitted to buy securities yielding less that the ECB's deposit rate, currently -0.2 %  --  that alone would rule out about a third of German bonds. And if it decided to widen the range of purchasable securities to include bank bonds and corporate debt, the ECB would be stepping into a potential minefield. Not only would the move expose the ECB's balance sheet to greater risk, but the choice of which bank or corporate debt to buy would at the same time be a political nightmare and compromise the ECB's role as a bank regulator.

So getting inflation moving again is not easy ..... particularly if you may lack the tools required.