Friday, September 7, 2012

Talk Boldly And Carry A Small Stick

The ECB has taken out its big guns, but conveniently forgot to take the safeties off (excerpt, emphasis added):

Introductory statement to the press conference
Mario Draghi, President of the ECB,
Vítor Constâncio, Vice-President of the ECB,

It is against this background that the Governing Council today decided on the modalities for undertaking Outright Monetary Transactions (OMTs) in secondary markets for sovereign bonds in the euro area. As we said a month ago, we need to be in the position to safeguard the monetary policy transmission mechanism in all countries of the euro area.

We aim to preserve the singleness of our monetary policy and to ensure the proper transmission of our policy stance to the real economy throughout the area. OMTs will enable us to address severe distortions in government bond markets which originate from, in particular, unfounded fears on the part of investors of the reversibility of the euro. Hence, under appropriate conditions, we will have a fully effective backstop to avoid destructive scenarios with potentially severe challenges for price stability in the euro area. Let me repeat what I said last month: we act strictly within our mandate to maintain price stability over the medium term; we act independently in determining monetary policy; and the euro is irreversible.

In order to restore confidence, policy-makers in the euro area need to push ahead with great determination with fiscal consolidation, structural reforms to enhance competitiveness and European institution-building. At the same time, governments must stand ready to activate the EFSF/ESM in the bond market when exceptional financial market circumstances and risks to financial stability exist – with strict and effective conditionality in line with the established guidelines. The adherence of governments to their commitments and the fulfilment by the EFSF/ESM of their role are necessary conditions for our outright transactions to be conducted and to be effective. Details of the Outright Monetary Transactions are described in a separate press release.

That’s the big talk…the details of the program are contained here. Unfortunately, its not a very big stick to whack the financial markets.

Key features are that countries who want to qualify for OMTs have to effectively ask for a bailout or are already under a bailout plan; there’s no limit on size or extent of bond buying; purchases will focus on the short end of the yield curve (1-3 years); and that all OMTs will be fully sterilised.

The first condition puts Italy in a real bind, because its the only one of the PIIGS that isn’t already under some form of formal assistance. Thankfully, its not quite as in trouble as Spain is.

The real kicker is the last one, and it undermines the entire exercise. Operationally what sterilisation means is that there will not be a true liquidity injection into the Eurozone banking system, just a swap of higher risk government bonds with zero-risk (and lower yielding) ECB bonds.

In terms of economic theory, the ECB is trying to leverage only on the interest rate channel of monetary policy, and not any of the others (like portfolio balance, or the exchange rate, or the money supply, or…).

I expect this to (not) work pretty much like the Fed’s Operation Twist last year. There should be some diminution of fear and uncertainty in financial markets with OMTs, but the final analysis is that this solves nothing but just buys more time.

1 comment:

  1. Makes you wonder who's going to buy ECB bonds when in the back of everyone's minds these bonds are backed by poor sovereign fiscal balances, just so it can be um...sterilised

    Germans are way to hung up on the money supply-inflation relationship, even in the face of a slow-motion depression.