The ECB 2015/16 asset purchase program will include sovereign and quasi sovereign debt, ABS, and covered bonds. The envisaged annualized pace of balance sheet expansion should be around 6% of GDP. Pace and size are conditional on inflation expectations and open-ended, subject to restrictions on market size and issuer quality. The absence of full loss sharing could limit benefits for sovereign credit risk.
A Bank of Italy paper illustrates the detrimental effect of a “negative cost push shock” (for example a commodity price drop) on an economy with low inflation and interest rates close to zero (such as the euro area). In normal times a downside cost shock would boost output. At the zero lower bound for rates, however, it would trigger a contraction, due to rising real rates and debt service.
The ECB has introduced a set of new policies that emulate quantitative and qualitative easing. Key measures are targeted long-term repo operations, asset-backed securities purchases, and covered bond purchases. The total net balance sheet expansion is expected to be at least 8% of euro area GDP over two years. Additional asset purchase programmes for corporate and sovereign bonds are possible in order to secure sufficient accommodation and to respond to contingencies.
It is evident that non-conventional Fed policy has contributed to long-term yield compression. It is less evident how this exactly worked and what will happen when the Fed tries to terminate QE and forward guidance. A new IMF paper supports evidence for two underestimated effects. First, to maintain existing stimulus the Fed must constantly announce new asset purchases or holding period extensions. Second, the stimulus from asset purchases depends on forward rate guidance and hence may decrease when the latter ceases.
Asset purchase programs have left the U.S. banking system with USD2.9 trn in (mostly excess) reserves. Raising the target federal funds rate in this predicament relies primarily on increases in the interest rate paid on excess reserves. Moreover, in order to secure a sufficiently pervasive impact, overnight reverse repurchase agreements will likely play an important role. Their exact form will influence whether or not the target floor on money market rates will be “leaky”.
Non-conventional monetary policy seems to benefit banks’ balance sheets. After all, it offers cheap refinancing and credit market support. However, an empirical analysis by Lambert and Ueda casts doubt on that belief. Market measures of bank credit risk have mostly deteriorated in episodes of policy stimulus. Easy monetary policy has been encouraging risk-weighted asset accumulation and discouraging balance sheet repair.
A new empirical study suggests that the Federal Reserve has exerted a stronger influence on fixed income, commodity, and currency markets since it started using non-conventional monetary policy. This is not because monetary policy shocks have been larger, but because their transmission has become more powerful and pervasive.
More than a year after its launch, the impact of “quantitative and qualitative easing” seems pervasive. The Bank of Japan asserts that the output gap has closed, that inflation expectations have increased, and that the conquest of deflation would be in sight. The policy board has maintained its commitment to the 2% inflation target through forward guidance and large-scale JGB purchases. However, without successful fiscal consolidation and supply side reforms this policy poses new serious risks.
Paul Mercier, principal adviser at the ECB, has summarized the basics and recent history of euro area money markets. His tale emphasizes what investors often miss. First, the ECB balance sheet and excess liquidity are poor measures of lending conditions. Second, the great financial crisis has generated a structural rise in banks’ borrowing from the Eurosystem, over and above their liquidity needs. Third, full allotment policies in conjunction with (sub-) zero deposit rates have led to large and potentially volatile excess reserve holdings.
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