Market Economics | Interest Rate Strategy - BNP PARIBAS ...

• Large holdings could result in large losses
and recapitalising the ECB could increase
political influence and threaten ECB
independence. In any case, the ECB would
be more politicised by the move; and
• Once you’ve started this, where do you stop?
How to do it
Should the ECB opt to embark on some forms of
quantitative easing, an important issue would be the
purchase allocation in terms of maturity and across
countries.
Should it be short or long-term debt? One constraint
for the ECB would be to minimize possible distortion
which suggests buying across the whole curve. That
said, two considerations suggest short-term debt
might be preferable. First, it would help ease
immediate funding pressures reducing therefore the
liquidity risk for many issuers. Moreover, it would
facilitate the ‘exit strategy’, a consideration that the
ECB gave priority to when designing the liquidity
injections. Short-term debt would not need to be sold
back to the market but it could simply be held until
expiration.
The allocation by country would pose another
significant challenge. A pro-rata allocation (either
linked to GDP or to contributions to ECB capital)
would help communication. It would be easy in this
case to sell the decision as a purely monetary policy
action, motivated for example by increasing risks of
deflation rather than an attempt to bail out this or that
country. On the other hand, it would dramatically
increase the size of total purchases needed in order
to make a material difference for the countries which
are currently under pressure.
The alternative would be to focus on the sovereign
debt of those countries under most stress, justifying
the choice with the ‘cheap’ price they offer under the
assumption that no country within the eurozone will
ever be allowed to default. An obvious drawback
would be the implied ‘moral hazard’ not to mention
the inconsistency with the ‘no-bailout’ clause of the
EU Treaty.
Of course, all these relate to long-term problems that
could result from short-term event-driven actions
intended with the best will in the world to avoid
problems today. We see an increasing risk that the
ECB does end up buying government debt, but we
would expect it to try to enhance liquidity first so that
it is private banks not the ECB that buy government
debt.
The trouble with such an approach is that many
banks already feel themselves to be overexposed to
risky governments. Increasing liquidity might not
work. The chances of outright ECB purchases are
increasing. They would support markets directly, help
to put a floor under bond prices and increase money
market liquidity at the same time. We can envisage
circumstances where they look like the least worst
option. The risk is, as so often in this crisis, too little,
too late.
Macro picture
Macroeconomic developments are obviously playing
second fiddle at present when it comes to listening to
what the ECB has to say. The assessment at this
month’s press conference was broadly similar to its
predecessor which was no surprise. There were a
few changes, however, which merit comment.
One was a reference to near-term risks to inflation
being “somewhat tilted to the upside”. The upside
risks relate specifically to external factors, however,
including higher oil prices and strong growth in other
parts of the world.
The medium-term assessment of inflation was as
before, i.e. pressures are low. The key to this is that
domestic wage and cost pressures remain contained.
The differentiation between the internal and external
influences on inflation we see as significant. It tells us
that the ECB will look through upward pressure on
inflation generated by factors beyond their control
and focus instead on domestic pressures which are
going to remain subdued.
The tone of Mr Trichet’s comments on growth was a
bit more positive than previously. Specifically, there
was a reference to the “strengthening” of the upturn
in activity during the spring. But in bigger picture
terms, the outlook was much as before. Growth rates
will remain moderate and the recovery uneven.
More flexibility
A new phrase was also slipped into the statement:
"Monetary policy will do all that is necessary to
maintain price stability in the euro area over the
medium term." We see this as a way of giving the
ECB more room for manoeuvre should they need it in
future - in both directions.
This is just the kind of phrase which could be used in
future should the ECB opt for the 'nuclear option' of
buying government bonds. Such action would then
be linked explicitly to the downside risks to price
stability. Alternatively it could be deployed should,
perish the thought, a surge in inflation and upward
pressure on inflation expectations necessitate a rate
hike despite economic and financial stress a la
summer 2008. The latter we continue to believe is a
much lower probability than the former.
Paul Mortimer-Lee/Ken Wattret 7 May 2010
Market Mover
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