Forecast
- The European Central Bank (ECB) will likely extend its quantitative easing program by another six months and alter its rules to increase the pool of bonds eligible for it to purchase.
- To mitigate the problems caused by the falling yields on German bonds, the ECB may amend the capital key rules. These adjustments could be announced at the Governing Council meeting on Oct. 20, but they are more likely to come in December.
- The changes to Europe's quantitative easing program likely will cause some consternation in Germany, but the resistance will not be strong enough to halt their progress.
Analysis
The European Central Bank (ECB) is in a bind. Since increasing its quantitative easing program in April, the institution each month has had to purchase bonds worth 80 billion euros (nearly $88 billion) to meet its self-imposed quota. But the pool of eligible bonds is shrinking and could run out before the end of the year. Meanwhile, the quantitative easing program is nearing its expiration date, set for March 2017. Soon, the ECB — under the watchful eyes of German politicians whose electorate is growing ever warier of the central bank's policies — will have to decide whether to extend the program. Despite the various factors complicating its decision, the ECB will probably opt to prolong its bond-buying regimen beyond March while changing its rules to increase the number of bonds eligible for purchase.
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A Predicament of the ECB's Creation
The limitations that the ECB faces are largely of its own making. As the central bank to not just one country but the entire eurozone, the ECB's unusual political position demanded certain parameters on its bond-buying program. To ensure fairness (and, no doubt, to assuage fears in Germany that the program might be used to subsidize Southern European countries), the program was designed so that bonds would be bought according to the capital key. In other words, the ECB would acquire bonds from each EU member state in direct proportion to its economy's share of the eurozone, making Germany — the eurozone's biggest economy — its main supplier. The ECB also limited the percentage of bonds it could buy from a single country or from any one issuance to 33 percent. In addition, it imposed restrictions related to a country's credit quality (eliminating Greece and Cyprus from the program) and set a minimum yield rate equal to its own interest rate, currently -0.4 percent, for the bonds it purchases.
Over the course of this year, it has become increasingly clear that the ECB would have difficulty meeting its bond-buying targets in accordance with its rules. Since Germany is the eurozone's most financially secure economy as well as its largest, its bonds are safer investments than those of its peers. As a result, the market's appetite for low-risk, reliable investments has driven the yields on German bonds ever lower, reducing the number of bonds that meet the ECB's interest rate criteria. So while the capital key rule requires the ECB to buy the highest quantity of bonds from Germany, the yield requirement restricts the number of bonds it can buy. This problem is accentuated by the fact that Germany is also one of the most fiscally conservative countries in the eurozone, meaning it has less debt and thus issues proportionately fewer bonds than most of its peers. If the ECB intends to see its quantitative easing program through to its expiration date, it will likely have to change its rules.
The program's appointed expiration date is also liable to change. The market reacted strongly to a Bloomberg News report in early October that the ECB was considering how it would wind down its bond-buying program. To allay investors' shock, several members of the ECB Governing Council downplayed the prospect of an imminent end to quantitative easing, and in subsequent days, talk has turned to extending the program instead. This is no great surprise; after all, the ECB introduced the program in January 2015 with the express intention of raising inflation to a target level of 2 percent. Though the central bank has since managed to escape the deflation it was experiencing when it introduced quantitative easing, inflation has reached only 0.4 percent. Similarly, growth in the euro area has returned, but its recovery is by no means strong, and removing monetary stimulus could undermine it.
Bending the Rules
In light of its predicament, the ECB will probably try to alter the rules and extend the duration of its quantitative easing measures. To do so, it has a few options. The central bank could, for instance, relax its capital key requirements, enabling it to purchase more bonds from other eurozone countries as needed to offset the shortage in eligible German bonds. Should the ECB need even more leeway to ratchet up its bond-buying, it could also readjust its purchasing limit on bonds from a single country. The current 33 percent limit could probably hit 50 percent before raising eyebrows about the political propriety of the central bank's holding so much of one country's debt. As for the program's future, the ECB will likely choose to prolong it by another six months.
Before making these changes, however, the bank will need to keep a close eye on Germany. Many leaders and voters in the country opposed its bond-buying program in the first place, and their antipathy has only grown since then; ECB President Mario Draghi got an earful from lawmakers when he spoke at the Bundestag in September. With federal elections looming — and considering the Euroskeptic Alternative for Germany party's considerable gains in recent regional elections — Germany's political establishment is sensitive to any issue it could use to galvanize voters. Though the ECB officially operates independent of euro-area governments, it has historically taken the wishes of Germany's political leaders under close consideration before making big decisions. In fact, German Chancellor Angela Merkel had a hand in creating the controversial instruments that helped the eurozone avert disaster during its 2011-12 sovereign debt crisis, and she met with Draghi the week before the bond-buying program began.
Notwithstanding its deference to the eurozone's largest economy, the ECB's prospective changes to the quantitative easing program are unlikely to rile German voters or their elected representatives, especially if they take effect before election season starts in earnest. More than its bond-buying program, the German public is concerned with the ECB's negative interest rate (known in Germany as a "penalty rate"), which hurts the country's many savers, banks and insurance companies. So far, Bundesbank President Jens Weidmann, an ECB Governing Council member, has been the only German leader to weigh in on the ECB's capital key, stating in September that he believed it should remain as it is. In spite of his dissent, though, the minutes from the ECB's last meeting suggest that Draghi has the support of enough other council members to push through policy changes if he chooses to.
And so, as the deadline approaches for its quantitative easing program, the ECB looks sure to extend it on slightly different terms, perhaps as soon as December. The decisions may meet with consternation in Germany and resistance from Weidmann, but the changes should pass nonetheless. There is no guarantee, however, that these adjustments will help solve the ECB's problems. If inflation does not bounce back, the central bank may have to resort to additional measures, such as further reducing the interest rate. These measures could stir up greater controversy closer to Germany's election, increasing friction in the eurozone. In the meantime, Draghi will keep hoping for a rise in inflation, as he has for the past two years.
"Europe's Central Bank Is in a Bind Over Bonds" is republished with permission of Stratfor.
