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 After the ECB cut interest rates in June and promised banks cheap
long-term loans starting in September, about all that is left is
printing money to buy bonds - so-called quantitative easing (QE).
But there are tricky practical and political barriers in the ECB's
way: it is boxed in by its own plans, and still faces strong
opposition from economic power Germany to any such monetary
leniency.
Already deployed by other major central banks, QE could be used to
pump money into the euro zone economy with a view to stimulating
growth and staving off deflation, which has already gripped some
countries in the bloc's south.
At just 0.4 percent, euro zone inflation is in what the ECB
considers a "danger zone". Economic growth, meanwhile, ground to a
halt in the second quarter even before the bloc has started to feel
the impact of sanctions on and by Russia over Ukraine.
Yet the ECB may be in a wait-and-see mode for some time, waiting
until the measures it announced in June kick in. The first tranche
of long-term loans it is offering banks to stimulate lending, called
TLTROs, is not available until Sept. 18, with a second shot in
December.
"What is happening in geopolitics is tilting the balance toward
having to implement further stimulus," said Andrew Bosomworth, a
senior portfolio manager at Pimco, the world's largest bond
investor.
"But I think there are a few things in the pipeline on the positive
side that we can point to as well, so we'd put a fifty-fifty chance
on QE right now, which brings me to the conclusion that the ECB is
in observe-and-analyze mode for now."
On the plus side, while the economy had no growth in the second
quarter, euro zone banks in the same period did ease lending terms
for firms for the first time since the start of the financial
crisis.
And as well as TLTROs, the ECB is also intensifying preparations to
buy asset-backed securities (ABS), which are created by banks
pooling loans into an interest-bearing bond that is sold to raise
funds.
The ABS market has not recovered following the global financial
crisis, but the ECB hopes that by supporting this segment it can get
credit to the smaller firms that make up the backbone of the euro
zone economy.
Any ABS plan is likely to be small, but the ECB expects take-up of
450-850 billion euros ($601 billion-$1.13 trillion) for the TLTROs,
potentially more than the total annual GDP of the Netherlands.
However, despite the queued-up stimulus, improving credit conditions
and the prospect of a more robust banking sector thanks to upcoming
health checks, France and governments further south want the ECB to
do more to buoy their economies, which they have been unable - or
unwilling - to shape up.
"I am convinced that more can be done and I'm also convinced that
the ECB is getting ready to do more," Italian Economy Minister Pier
Carlo Padoan told the BBC at the weekend.
Indeed, a Reuters poll of euro money market traders gives a 50
percent chance that the ECB will resort to QE-style asset purchases
to boost inflation in the coming year.
QE QUANDARY
But waiting for evidence that what it has done is working is only
part of the ECB's QE dilemma. Some policymakers believe QE is
inappropriate; others are not sure it would work anyway.
Hawkish ECB policymakers are still deeply resistant to the idea. For
example, ECB Executive Board member Sabine Lautenschlaeger, a former
member of Germany's Bundesbank, said last month it needed a "real
emergency" for a broad asset-buying plan to be deployed.
"Technically there are quite a few people in Frankfurt who are not
absolutely sure QE would have a significantly positive impact on
growth," said Deutsche Bank economist Gilles Moec.
Some euro zone officials argue the ECB would need to spend huge
amounts on a broad asset-buying plan to have any impact, and that
this would probably only be marginal as sovereign bond yields are
already near historic lows.
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There is also the issue of what to buy. In the United States, where
the economy is based on capital markets, Federal Reserve purchases
of U.S. Treasuries and mortgage-backed bonds had an impact across
asset prices, holding down borrowing costs.
But in the euro zone, the economy is based on bank lending, so
buying sovereign bonds may not be as effective. ECB Executive Board
member Benoit Coeure said earlier this year any euro zone QE plan
would have to be tailored to the bank-based economy.
Buying sovereign bonds according to the ECB's capital key - the
share each euro zone country's central bank has in the ECB's
capital, based on the size of its economy - would see large
purchases of German bonds, the merits of which are questionable as
their yields are already near record lows.
Padoan, the Italian economy minister, acknowledged this:
"Quantitative easing has worked well in the U.S.... but of course
the underlying economic structure of the U.S. economy is largely
different from the still-fragmented euro area."
FED FACTOR
Policy developments across the Atlantic could actually play into the
ECB's hands. While the ECB considers how to loosen policy, the Fed
has started reining in its expansive tools and is preparing to raise
interest rates, perhaps in mid-2015.
A recent Reuters poll of 74 analysts showed the Fed is not likely to
raise rates until the second quarter next year, most likely in June.
Interest rate futures are pricing the first rate hike in the third
quarter of next year.
"The ECB would jump for joy," said Hans Redeker, global head of
foreign exchange strategy at Morgan Stanley, referring to the
implied dollar strength that such a step would bring with it.
"This would also mean euro weakness and that is exactly what the ECB
wants. It would ease pressure, because further steps from the ECB
would be less necessary," he said, adding exports, especially from
the periphery, would become more competitive.
An ECB pledge to keep interest rates at present levels for an
extended period of time is also seen stabilizing the situation in
such an event.
A weaker exchange rate may be more effective at generating growth
than ever more liquidity that struggles to find its way to companies
and households as banks remain reluctant to lend while tidying up
their balance sheets.
The euro has weakened more than 4 percent since scraping by the
$1.40 mark in May. But it is still too strong for some periphery
countries, such as Italy.
Morgan Stanley calculated what it called a "fair exchange rate", at
which a country would be able to maintain a sustainable trade
balance and an exchange rate that would not have a long-term
negative impact on growth conditions.
Italy's fair exchange rate would be $1.20 and Germany's $1.53,
Redeker said, showing how diverse the economies are.
($1 = 0.7492 Euros)
(Editing by Jeremy Gaunt)
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