ECB policy framework in six basic points

January 26, 2019

The European Central Bank is one of the most powerful institutions in the world and is running a particularly complex policy framework. For macro trading and financial modelling, the following points are critical: [1] The primary policy objective is medium-term inflation, with a horizon of two years or more and symmetric aversion to deviations from a mean of just below 2%. [2] In practice, policy rate setting has followed a simple dynamic Taylor-type rule. [3] The operational framework is very broad, with a wide range of counterparties and instruments. [4] The ECB has extensive experience with four types of non-conventional policies (long-term lending operations, asset purchases, negative interest rates, and forward guidance) that jointly exercise powerful influence on financial conditions. [5] The effectiveness ECB policy depends critically on coordinated national fiscal and regulatory policies. [6] Special mechanisms have been put in place to contain redenomination risk, i.e. fears that assets might be redenominated into legacy currencies.

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Monetary policy stance in one indicator

November 25, 2017

New research proposes to condense policy rates and balance sheet actions into a single implied short-term interest rate. To this end the term premium component of the yield curve is estimated and its compression translated into an equivalent change in short-term interest rates. This implied short-term rate can be deeply negative and allows calculating long time series of the monetary policy stance including times before and after quantitative easing. It is only suitable for large currency areas, however. Indicators of smaller open economies should include the exchange rate as well, as part of an overall monetary conditions index.

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The global effects of a U.S. term premium shock

April 22, 2017

Empirical research suggests that shocks to U.S. treasury term premia have had a persistent subsequent impact on term premia in other developed and emerging fixed income markets. Global financial integration and inflation seem to increase the sensitivity of non-U.S. markets. A 200bps rise in the U.S. premium from current compressed levels could boost the term premia in other countries between 50 and 175 basis points. Hence, a U.S. shift towards reflationary policies or greater net supply of long-term treasuries could greatly increase borrowing costs around the world, exposing weaknesses in overleveraged economies and sectors.

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Japan’s yield curve control: the basics

October 8, 2016

The Bank of Japan has once again broken new grounds in monetary policy, now targeting not just the short-term policy rate but – within limits – the 10-year JGB yield. In practice the Bank will secure a positive yield curve against the backdrop of negative short-term rates and negative expected long-term real rates. This is meant to mitigate the debilitating effect of yield compression on the financial system and, probably, to contain the risk of bond yield tantrums in case domestic spending and inflation do pick up. As a side effect, the policy would subsidize long duration carry trades and long-long equity-duration risk parity positions.

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ECB asset purchases: the three transmission channels

September 24, 2016

A new paper suggests that ECB asset purchases influence markets and the economy significantly, mainly through three channels. First, through the asset valuation channel they reduce risk premia and provide capital relief to leveraged institutions, particularly banks. Second, through the signalling channel they enhance the credibility of rates staying low for long. Third, through the re-anchoring channel, asset purchases can reassure the private sector that the central bank remains committed to its long-term inflation target.

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The side-effects of non-conventional monetary policy

July 30, 2016

A BIS summary of research gives a nice overview on non-conventional monetary policies and their unintended systemic consequences. Current policies appear to yield diminishing returns in terms of easier financial conditions, while their costs and side effects are increasing. This leaves markets more exposed to future negative shocks. Also, the descent into negative nominal interest rates is itself a drag on profitability and health of the financial system that erodes the effectiveness of non-conventional policies.

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“Helicopter money”: A practical guide for markets

June 11, 2016

If current non-conventional monetary policies fail to contain deflation risk, some form of debt monetization or “helicopter money” will become a policy option. The barriers are high but not insurmountable in the G3. Policies could range from a simple combination of QE and fiscal expansion to outright central bank funding or debt restructuring. If and when monetization of government debt becomes apparent the consequences for financial markets would be profound: the policy response to deflation risk would no longer drive bond yields lower but higher.

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The limitations of ECB bond purchases

March 5, 2016

The European Central Bank’s public sector bond purchases are sizeable and their pace may increase further. However, issue and issuer limits constrain their time horizon. For monetary easing to remain credible and powerful the purchase of uncovered bank bonds and corporate bonds may have to be considered.

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The impact of the ECB asset purchase programme

November 19, 2015

ECB research suggests that its 2015 asset purchase programme significantly compressed term and credit spreads. Unlike previous asset purchases, it did not tackle financial distress. It functioned mainly through the broad compression of risk premia and spill-over to non-targeted assets.

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ECB asset purchases: key points to memorize

January 24, 2015

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.

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