Market Will Decide ECB’s Self-Imposed Limits

The European Central Bank performed as expected last Thursday, cutting the amount of its monthly bond purchases in half to €30 billion ($35.01 billion) while extending the program at least through September. This move was at least partially driven by concerns that the 60-billion-per-month pace would be unsustainable under current program rules.

While the ECB declined to put an official end-date on its quantitative easing program, analysts expect the ECB to run out of eligible bonds to buy around September of 2018 given its current structure of asset purchases. It’s fair to wonder how the ECB, with the ability to create new money out of thin air, could run into limits on its purchases, Steven Kelly, member of the European Horizons Alumni Network, wrote for HuffPost.

The hitch is due to a rule the ECB has imposed upon itself in its quest to improve economic conditions in Europe. To avoid violating its founding treaty’s prohibition of ‘monetary financing’ of governments—that is, printing money purely for the purpose of funding profligate government expenditures—the ECB, already late to the global QE party, imposed limits upon its own asset purchases.

These limits stipulated that the ECB not purchase more than 33% of a government’s outstanding stock of debt and were put in place to fend off legal challenges to such stimulus—challenges already overflowing out of Germany—which, thus far, have been quashed by the European Court of Justice.

 Given Germany’s unduly restrictive spending habits, and the QE program’s design to purchase government debt in proportion to eurozone members’ relative economic size, the ECB will soon run out of German bonds to buy, implying a halt to all sovereign bond purchases.

  Forced Ending

This effectively means that the ECB will be forced to end such purchases regardless of the state of the eurozone economy—the opposite of good central bank policy which would underwrite the economy by promising to leave stimulus in place at least until the economy was sufficiently strong. Indeed, by the ECB’s own (consistently overly optimistic) projections, inflation and growth will remain meager come September.

The self-imposed limits are either a result of ECB policymakers’ lack of understanding of monetary financing or their lack of ability/will to communicate what true monetary financing looks like. The restriction on such financing by the ECB was written into its founding treaty to prevent the excessive inflation of government spending financed by the printing of money—think 1920s Germany, where paper currency was being swept into sewers and restaurant prices were changing between when the food was ordered and when the check came.

This is clearly a stark contrast from the current reality of policymakers struggling to increase inflation a few tenths of a percentage point.

It is important to remember that central banks do not set interest rates in a vacuum. Rather, they attempt to align interest rates with market-determined, or so-called ‘market clearing’, interest rates—the level of interest rates needed to bring economic output to potential. For the ECB to credibly pursue its price-growth mandate, it must be able to set interest rates at the market-clearing level—which, in a low-interest-rate environment and/or acute crisis may very well call for buying up more than 33% of outstanding government bonds.

  Credibility to Continue the Fight

The fact is that if the ECB would like its QE program to have the credibility to continue to fight this downturn as well retain the ability to be scaled up to fight the next, it needs to change its own rules. It needs to communicate that the standard for ‘monetary financing’ will no longer be some arbitrary cap on its asset purchases (i.e. 33% of a country’s sovereign bonds), but will be judged based on economic outcomes.

This could be done relatively simply and while staying in the favor of the ECJ. For instance, currently, for a country to be able to join the eurozone, it must manage its annual inflation to the point that it does not exceed the average of the three lowest-inflation European Union countries plus 1.5%.

This rule could also be adopted as the new ‘cap’ on QE operations to avoid monetary financing and excessive inflation. So, instead of being forced to terminate or slow its program of buying sovereign debt while inflation and growth are still tepid, the ECB would be able to continue its monetary easing at least until the economic outlook was on more solid footing.

The fact that elected governments benefit from a central bank’s actions need not imply ‘monetary financing’. In fact, it should imply an opportunity for public institutions to work in harmony toward a common goal. This is clearly quite distant from the reality one observes amongst European policymakers today. This is a policy choice, not an unavoidable reality.

  Clear-Cut ‘Tapering’

The ECB could start a more defined ‘tapering’ of its stimulus program next September, one of its policymakers said on Friday, even though it was likely to struggle meeting its inflation target for years, Reuters reported.

The ECB announced last week that from January it would reduce its bond-buying program to €30 billion a month from its current €60 billion.

However, inflation in the eurozone remains stubbornly below the central bank’s target of just under 2%, which is the main reason it has been cautious about reducing the two-year-old stimulus program.

“This goal of 2% or 1.9% is something that will not be easily reached in the years to come,” said Ewald Nowotny, a long-serving member of the ECB’s Governing Council.