Friday, March 7, 2014

07/03/2014: To sterilise or not to sterilise... ECBs (possible) next dilemma

Yesterday, I was asked by a journalist a question about the possible effects of ECB non-sterilising SMP operations. 

The question was in relation to the measure that has been rumoured as being a part of the ECB’s toolkit under consideration for adoption and it is bound to come up in the next meeting of the GC.

The answer is that we do not know.

Currently, ECB is sterilising around EUR175 billion via weekly operations. Absent such sterilisations, the money will remain within the euro system banks. This is as far as we know. Beyond this point, we can only speculate as to what will happen. 

In normal monetary and balancesheet conditions, banks will lend this money out into the interbank markets, leading to reduced Eonia and, downstream also Euribor, rates. This, in turn, will increase banks willingness to lend to the real economy - businesses and households, but also to purchase government debt. Traditionally, non-sterilised market interventions are seen as an effective tool for increasing money supply in the environment of zero-bound interest rates. And there are good reasons to believe that such a measure would be more effective in raising supply of credit in the euro system than a 25bps cut in the policy rate, as it will likely have a more dramatic effect on Eonia rate and simultaneously flatten the money market curve. Additional benefit of such a measure will be the signal it will send to the markets. Removing requirement to sterilise its SMP, ECB will be signalling that it is open to the traditional QE measures - extending 'whatever it takes' argument from sovereign risk markets (OMT) to the real economy (deflation risks). This too is likely to add liquidity available in the euro system.

However, we are not in a 'normal' monetary and balancesheet environment. Increasing supply of liquidity via non-sterilising SMP can lead to banks substituting away from their normal ECB funding, and as the result, net liquidity supply may not rise by as much as the reduction in sterilisations. 

Two other, longer-term, effects of non-sterilising SMP are: potential loss of credibility and threat to OMT.

By not sterilising SMP, the ECB will signal a major departure from its past commitments, which does not help market confidence in its other commitments, namely the commitment to hold interest rates low over long term horizon. This is a relatively weak argument against non-sterilising of SMP, as all long term monetary policy commitments are only credible as long as underlying fundamentals warrant them. The second point is more salient. ECB committed itself to sterilising not only SMP but also OMT purchases. So far, ECB did not make any OMT purchases, but it already faces stern opposition to OMT from Germany. If ECB signals willingness to break its commitments to sterilisation under SMP, it can send a wrong signal on its commitments to the same under OMT, further putting pressure on ECB to scrap OMT.

Overall, materially, removing requirement to sterilise SMP will, in my view, result in a moderate drop in Eonia and will provide improved supply of credit to the economies that currently do not witness severe credit constraints, such as Germany, where current credit supply conditions are already the most favourable of any period in recent history.

But I doubt that such a measure will have a material impact on peripheral economies due to the general breakdown in the transmission mechanism within the euro area.

Crucially, if ECB opts for non-sterilisation of SMP over the option of lowering policy rates, such a move will not help existent debtors. As the result, non-sterilisation might help where help is least needed and will do little to provide any support for economies with severe corporate and household debt overhang.

Finally, along the longer range expectations, forward-looking agents will be pricing – in the wake of non-sterilisation now – higher uplift in lending rates when monetary policy returns onto normalisation path. In other words, with non-sterilisation today we can expect higher rates in the future, with sharper rises in the rates to long-term trend levels. This too will hurt current borrowers, as lender will be less likely to pass on margins uplifts they will receive if non-sterilisation does deliver reduction in the interbank lending rates.

Note: my view of the lower/reduced effectiveness of non-sterilised interventions is in line with the view held by many researchers and the ECB that we are operating in the environment with broken transmission mechanism. Application of this argument in the OMT case is exemplified here:

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