ECB Barrel Scraping Getting Louder?

There was never any doubt that the ECB would ease policy at today’s Governing Council meeting. In the event, however, it beat expectations, adjusting policy in several different ways:

(1) Further rate cuts. The ECB predictably cut the deposit rate by 10 bps to -0.40%, but also unexpectedly reduced the main refi and marginal lending rates by 5bps to zero and 0.25% respectively. The door to further rate cuts was left open with forward guidance stating that rates will remain at the new levels or below for an extended period of time, and well past the horizon of the asset purchase programme (currently due to end in March 2017).

(2) Increased asset purchases. The monthly purchases under the ECB’s asset purchase programme will be expanded by a greater-than-expected €20bn to €80bn starting in April. Investment grade euro-denominated bonds issued by non-bank corporations established in the euro area will be included in the list of assets eligible for purchase. And while the precise list of eligible names was left vague for clarification in due course by the ECB committees, we estimate that this will amount to an additional €720bn of bonds that will be eligible for purchase The issuer and issue share limits for the purchases of securities issued by eligible international organisations and multilateral development banks, meanwhile, were increased from 33% to 50%.

(3) More, and more innovative, long-term liquidity operations. A new series of four targeted longer-term refinancing operations (TLTRO II), each with a maturity of four years, will be launched, starting in June 2016 and conducted in each of the three following quarters. The last of these new TLTROs will therefore mature in March 2021. While funds borrowed under the operations will be subject initially to the refi rate prevailing at the time of take-up (0% currently), for banks whose net lending exceeds a benchmark the interest rate will be lowered and can fall to as low as the deposit rate (-40bps) – the ECB will effectively be paying banks to borrow money. And unlike the original TLTRO operations, under which banks who failed to meet the lending benchmark will have to repay funds, there will be no requirement for mandatory early repayments.

The overall package, therefore, exceeded expectations. And the innovative nature of the new TLTRO programme, whereby banks will be incentivised to lend into the real economy with the carrot of being paid to borrow from the ECB, should be more effective at the margin at supporting bank lending. But the cost of finance is only one consideration for banks when deciding whether to lend or not – of at least equal importance is how the underlying economy, and hence the loan itself, is expected to perform. And on that measure it’s far from certain that today’s announcements will prove transformative to the economic outlook. Indeed, the ECB’s own forecast for 2017 sees growth of just 1.7% and inflation well below target at just 1.3%.

Our own forecast sees growth of just 1.3% next year, and the ECB will likely eventually have to do more to support growth and boost inflation. But today’s announcements also highlighted that the ECB’s options are narrowing. While it lifted the self-imposed issue and issuer share limits on purchases of bonds from the likes of the EIB to 50%, the limits were unchanged for its government bond purchases. At the same time, it failed to remove the yield floor on its bond purchases (set at the level of the deposit rate). Both of these restrictions limit the amount bonds it can purchase and mean that it might find itself unable to buy sufficient bonds to meet its asset purchase target just over a year from now. So, any extension of its asset purchase programme beyond its current planned March-2017 end point will be problematic under the current constraints, not least given that the addition of corporate bonds to its purchase programme has eliminated the last of the large bond markets it is likely to be willing to tap (assuming that it will not buy bank bonds). And if the ECB has fundamental concerns over whether it has the legal power to purchase bonds at yields below the deposit rate or hold a blocking minority of government debt containing CACs, then removing these constraints may prove impossible. As such, much like the BoJ’s end-January decision to move to a negative interest rate in some ways highlighted its diminishing asset purchase options, today’s move by the ECB to a more innovative TLTRO framework could be seen in a similar light. The days of Draghi’s bazooka firing big asset purchase shots look like they could be behind us.

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