In medicine, the “therapeutic threshold” refers to the minimum amount of a drug required to produce the desired effect, while the “loading dose” is the amount, administered over several closely spaced doses, needed to obtain this threshold.
Achieving the right dosage can be tricky, and the European Central Bank (ECB) faces a similar challenge at its Governing Council meeting in Frankfurt next week. It must decide on the minimum amount of quantitative easing (QE) needed to return inflation to target – and in what size doses it should be administered.
The ECB has conducted two rounds of QE so far and committed to buy €1.74 trillion in assets, mostly government bonds. Phase one began in March 2015, spanned 13 months and saw €60 billion in asset purchases per month; phase two began in April of this year and is scheduled to run for 12 months at a rate of €80 billion per month.
Striking the right balance between the stock (of assets to purchase) and flow (the rate of purchases) will be key. Both current inflation and projections for next year remain far below the ECB’s just-under-2% target, supporting the argument for more QE at a high monthly purchase rate. But monetary policy works with a lag, and because the ECB has already administered a lot of easing, further purchases risk creating asset bubbles and hurting savers – an argument for phasing out QE as soon as possible.
So what is the ECB to do?
There may appear to be little difference between purchasing €80 billion in assets per month for six months and purchasing €60 billion in assets for nine months (two options likely to be on the table). But while the ECB might be tempted to reduce the monthly purchase rate now, we think maintaining higher monthly purchases for a shorter period is more likely to square the stock-versus-flow circle, for three reasons.
First, maintaining €80 billion in monthly purchases minimizes the risk of tightening financial conditions, even if it involves purchasing a smaller total stock of assets. Financial markets are sensitive and might interpret a smaller purchase rate as a signal that QE will stop soon.
Second, committing to a shorter-term policy gives the ECB more flexibility to change course. If it turns out that nominal economic growth recovers strongly and durably – say, above 3.5% – the ECB could slow purchases during the final quarter next year and stop altogether by mid-2018. If growth remains weak, it could opt to extend QE into 2018. We see little cost to postponing the decision.
Third, interest rates and the euro are likely to rise for fundamental reasons independent of QE once growth recovers. Winding down QE under those circumstances would reduce the risk of tighter financial conditions that could push the economy back into recession. From a risk management perspective, we think it’s better to delay reducing monthly purchases until there is a high degree of confidence in economic forecasts.
Loosening the rules
Owing to the scarcity of eligible Bunds, any extension of QE will likely require relaxing some of the ECB’s rules for purchasing government bonds. We believe the ECB may change its rules so that it can buy bonds at yields below the deposit facility rate and in quantities that deviate from its capital key. With so much government debt on its balance sheet and peripheral banking systems (especially Italy’s) dependent on ECB liquidity as never before (see chart), a sovereign debt restructuring would be a crisis for the ECB. We therefore think relaxing the 33% cap on purchases for any one bond or issuer is less likely, and may be left in the toolkit for the next recession.
Let’s hope that’s a long way away.