Consequences of bond purchases by ECB
The European Central Bank’s ultra-expansive monetary policy and sovereign bond purchase programme are fuelling worries about inflation among analysts and others.
The ECB’s first tender of three-year loans in the week before Christmas probably aggravated this anxiety. Commercial banks were allotted three-year loans to the tune of EUR 489 billion. However, against the background of crumbling confidence anda faltering global economy the danger of inflation is strictly limited – deflation risks predominate. Inflation rates look set to ease in the months ahead.
The ECB’s sovereign bond purchase programme now amounts to EUR 211 billion. There are widespread fears that this will drive up inflation. Many investors are rushing to protect themselves – as reflected in the continuing high gold price. On the other hand, the inflation rates priced into inflation-protected securities are at a moderate level.
Commercial banks hold reserve accounts with central banks. When the ECB buys sovereign bonds from banks, the proceeds initially go into these accounts, and the monetary base (money in circulation plus commercial banks’ reserves with the central bank) therefore rises. If the commercial banks use these additional reserves to make increased lendings to clients, M3 money supply (the monetary aggregate that drives inflation) will grow. It is only at this stage that bond purchases generate a potential inflation risk. If the ECB buys bonds directly from private investors (non-banks), the proceeds go into the seller’s account at a commercial bank. This immediately causes an increase in M3.
Deflation risks predominate
Nevertheless, deflation risks predominate. In the present difficult macroeconomic environment, companies are unlikely to go to the banks for new loans to finance additional investment, and households are unlikely to spend extra cash on consumption. On the contrary, sales of peripheral Eurozone government bonds are evidence of pessimism. That tends to push up the saving rate. The saving rate in the Eurozone now stands at 13.7% of disposable income, testifying to a strong desire for security. Apart from that, inflation pressure would in any case be limited. Even if the extra money is spent, the theoretical connection between rising money supply and accelerating inflation is not an iron law. When there is idle production capacity in the economy, companies usually opt for increased output rather than higher prices.
Impact of monetary ease
In the context of its open market operations, the ECB is now providing the commercial banks with unlimited liquidity. The supplied liquidity made available since August is just over EUR 4.5 trillion, including the recent three-year tender. This is widely seen as a further potential driver of inflation, alongside the bond purchase programme. It is feared that this extra liquidity will prompt increased lending and thereby fuel price increases. The main reason for the increase in ECB financing is the commercial banks’ lack of confidence in each other. Banks are now holding their cash reserves with the central bank rather than with other commercial banks. Thus the extra liquidity leads to an expansion of the ECB’s balance sheet rather than the balance sheets of the commercial banks. Economically, nothing has changed.
Moreover, apart from the inhibitions mentioned above, banks’ lending activities are increasingly determined by the need to match maturities between loans and deposits. To enhance the stability of the financial system, the new capital requirements under Basel III will limit banks’ scope for financing long-term loans with short-term deposits. As short-term interest rates are usually lower than at the long end, this results in higher costs and narrower margins.
Even if the ECB provides the commercial banks with more liquidity, that does not necessarily mean increased lending and resultant inflation risks. More important is the banks’ ability to raise long-term capital on the bond markets. This is very difficult at the moment. Mutual mistrust among the banks is high, and justified worries about the solvency of many banks are making private investors reluctant to buy bank bonds. The results are serious:
• Dwindling scope for matched-maturity refinancing significantly limits long-term lending opportunities.
• The inability of some banks to raise finance on the capital markets means a downsizing of their balance sheets, with substantial repercussions on their ability to lend – regardless of the ECB’s ultra-expansive policy.
Thus deflation dangers persist. The liquidity being provided by the ECB is merely pushing up the monetary base, as happened in 2008. The transmission mechanism into the economy at large has been disrupted. The commercial banks are putting the cash received from the ECB straight back into ECB overnight deposits.
Inflation risks averted?
The basic preconditions for a future acceleration of inflation rates are:
• A strong upturn in economic activity. Only when industrial capacity is fully utilised will manufacturers have scope for putting up
prices.
• Confident consumers. Confidence in the economic outlook must be strong enough to encourage households to consume or invest on credit.
• Confidence in the banking sector. If banks are able to raise sufficient long-term finance on the capital markets, short-term money
provided by the central bank can also act as a driver of additional lending.
None of these conditions is met at present. We therefore expect inflation rates to stay low over the coming year. In some countries, Greece and Portugal for example, deflation is the threat. Investors who nevertheless believe that inflation rates are set to accelerate should consult their client advisor about our recommendations for inflation protection.
Dr Jörg Zeuner is Chief Strategist and Chief Economist at VP Bank Group in
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