ECB takes a gamble with ‘credit easing’

In July 2012, a few well chosen lines – “we will do whatever it takes, and believe me, it will be enough” – were sufficient to reverse eurozone break-up expectations, pull peripheral European bonds out of a nosedive and ensure the continued functioning of the single currency.

During a central bank conference at the end of August, Mr Draghi drew attention to the recent decline in inflation expectations in Europe. This was enough to spark panic-buying in all eurozone government bond markets, induce an abrupt reversal in European equity prices and push the euro on to a sharply weakening trend.

Finally, at the most recent ECB meeting in early September, the ECB president caught markets on the hop by cutting all three key policy rates and announcing a surprise asset purchase programme.

The first point is to acknowledge the speed at which inflation expectations in the eurozone have deteriorated over the summer months. No inflation-targeting central banker worth his salt could admit to the decline in inflation expectations and not put something in place to reverse this trend.

At the same time, the recent central bank announcement feels like a scramble to regain the initiative. The urgency in putting together an untried range of measures smacks of policy making on the hoof. At the June ECB meeting, the impression given was that policy rates were already at the zero lower bound and that private sector mortgage lending was unlikely to be pursued. Instead, the focus was on increasing the flow of credit through the banks through the ECB’s targeted longer-term refinancing operations (TLTROs).

But given the intensifying disinflation that has become evident since June, lower policy rates and an asset purchase programme are now considered the minimum by the ECB to stop the rot.

The central bank officially describes its TLTRO programme and its new asset-backed securities (ABS) purchase programme as credit easing, rather than quantitative easing (QE) but there is no generally accepted definition of the difference between the two.

What matters instead is the size of the purchase programme and its effect on boosting the ECB’s balance sheet, rather than the type or composition of assets involved. The inference of many market participants is that it is only a matter of time before outright purchases of sovereign assets by the ECB takes place.

There is considerable debate as to how effective QE has been in the US and how it achieved its objectives.

In trying to quantify the effects of QE in the US, a study by the Federal Reserve Bank of San Francisco calculated that $600bn of long-term asset purchases was only able to lower the 10-year Treasury yield by 15-25 basis points. What the US experience also shows was that QE had its greatest effect in 2009 during its first phase when financial markets were barely functioning.

By intervening in the Treasury and mortgage-backed securities markets at that time, the Fed provided reassurance that there was a liquidity backstop in place to enable markets to keep on functioning. This may have been its single most important effect.

European markets are quite clearly less stressed at present, so it is not clear whether similar official interventions will have the same effect. There are also some obvious differences in the nature of the eurozone’s financial structure, which may change how policy stimulus can be transmitted. Unlike that of the US, the eurozone’s is an overwhelmingly bank-based financial system, in which credit extended is largely held through loans on bank balance sheets. By forcing investors out of ABS or covered loans, it is not clear whether the funds freed up will find their way to credit-starved European enterprises.

Whether the combination of policies so far announced by the ECB will be enough to free up the monetary transmission mechanism, remains to be seen.

Jonathan Lowe is managing director of the global multi-asset group at JPMorgan Asset Management