How can the ECB ease further? Buy US treasuries
The European Central Bank (ECB) meets later Thursday for its monthly monetary policy meeting. The market does not expect Mario Draghi to cut interest rates despite deflationary threats faced by the euro zone, especially the periphery. Inflation has stubbornly remained below the central bank’s target of 2 percent.
The areas common currency, the euro, is hovering around the 1.38 level against the US dollar. In recent weeks, many senior officials at the ECB and Bundesbank have expressed their concerns over the euro being too strong at current levels as it hurts the international price competitiveness of the region’s exports. But till now, the central bank has not walked its talk of driving the euro lower.
The main interest rate is currently near the zero bound and even if the ECB eases, it will soon run out of conventional monetary policy tools. So what can the ECB do? Some argue it can engage in Quantitative Easing like Japan and the United States. But as things stand, this cannot be implemented.
The ECB, unlike the BoJ and the US Federal Reserve, has no centrally issued and traded ‘Eurobond’ that the central bank can buy to inject liquidity. Thus, it raises the economic debate over the introduction of such bonds.
If the ECB purchases bonds of each of the euro zone member countries, it would be taking implicit positions on their individual creditworthiness. This too, from the point of view of risk management, is hard to implement. Further, there is also the case that doing so is outside the mandate of the ECB. This case is with the European Court of Justice and a decision is not expected anytime soon.
Lastly, the ECB engaging in some sort of QE also raises the ‘moral hazard’ issue. If Germany, a creditor nation does indeed bail out Greece, what is the guarantee that Greece will follow a fiscally responsible path in the future?
So, taking the above points into account, the ECB engaging in QE like the BoJ and the US Fed becomes a very low probability event.
Jeffery Frankel, a Harvard professor, believes that the ECB should buy US treasuries. Doing so would face no legal obstacle as intervening in the foreign exchange market is well within the central banks remit. Further, it would drive down the exchange rate against the US dollar, thus reviving exports.
Frankel believes, “Monetary expansion that depreciates the currency is more effective than monetary expansion that does not, especially when, as is the case now, there is very little scope for pushing short-term interest rates much lower.”
The euro has held up remarkably well over the past one year and the ECB must act to restore price competitiveness. Periphery bond yields have dropped over the past few quarters and risk apatite is returning to the system as can be seen by the Greek 5-year bond issue this week. For this recovery to continue, the ECB must take a stand against deflation and push the Euro lower.