Running dry

The European Central Banks quantitative-easing options

The ECBs willingness to do whatever it takes helps explain the markets uneasy calm

Dec 10th 2016

THE response of bond, stock and currency markets to the result of Italys
referendum, and the resignation of its prime minister, Matteo Renzi, was a jawbreaking yawn. The euro fell a bit against the dollar, and then rallied. The yield on
Italys ten-year bonds ticked up a few basis points and then fell to 1.89%. The
markets had expected a No vote and priced it in, is one view. The calm probably also
owed much to a belief that the European Central Bank (ECB) would act to stem any
panic.
As The Economist went to press, the ECBs governing council was widely expected
to extend its monthly purchases of government and other bonds (quantitative
easing, or QE) beyond March 2017. These purchases (which began at a monthly
rate of 60bn and then increased to 80bn), plus the ECBs myriad schemes to
provide long-term liquidity to banks, have worked like a charm. Financing costs in the
euro zones periphery have converged on those of core countries (see chart). All
governments, apart from Greece, can borrow in bond markets at tolerable rates. A
nagging worry is that the ECB cannot keep up this support forever. Yet most
observers think it can soldier on for a while yet.
The ostensible reason for QE is not to calm markets but to meet the ECBs inflation
goal. The headline rate rose to 0.6% in November, up from 0.1% a year earlier, but it
is still well below the ECBs target of close to 2%. Strip out volatile prices of food,
energy, booze and tobacco, and core inflation has been stuck at 0.8% for months.
Yet the economy has been doing rather well by the shrunken expectations of euro
land. GDP growth was steady at an annual rate of 1.7% in the first three quarters of
2016. A closely watched index of activity based on surveys of purchasing managers
suggests that growth has picked up a bit more recently. Unemployment has fallen
from 10.6% to 9.8% in the past year, with some of the biggest declines in the former
crisis countries of Spain, Portugal and Ireland. Even Greeces economy is improving.
Still, the ECB cannot afford to rest on its laurels. Economic tailwinds, such as a
weaker euro and cheaper bank credit, will not always have the same puff.
The ECB does face some constraints. One is politics. It is more independent than its
peer central banks, but even it requires political cover for contentious policies. That
is why its president, Mario Draghi, got himself invited to the Bundestag in October
2012. He sought to defend from German criticism his famous pledge to do whatever
it takes, including unlimited bond purchases, to save the euro. To some German
ears, this sounded like the monetary financing of governments, which is barred by
the treaty governing the EU. It helps that Angela Merkel, Germanys chancellor,
blessed the scheme, dubbed Outright Monetary Transactions, or OMTs, and that the
ECB has not yet been called upon to use it. Germany still suffers frequent bouts of
grumpiness at ECB policy. The finance minister, Wolfgang Schuble, said in April
that the ECB is half to blame for the rise of the populist Alternative for Germany

(AfD) party. Yet if the ECB were forced to act in unorthodox ways to stem a financial
crisis, leading German politicians would be unlikely to make a fuss.
Some constraints are likely soon to be relaxed. To abide by the prohibition on
monetary financing, the ECB has set a limit, of 33% of the total, on the purchase of
any one countrys public debt, as well as on each individual bond issue, under its QE
programme. It also tailors its purchases to the economic weight of each euro-zone
country (the so-called capital key). If purchases continue at a monthly rate of
80bn, eventually the ECB will hit its self-imposed limits. Bonds will become
particularly scarce in Germany, which is supposed to supply 26% of total purchases,
but is running a budget surplus and so has a shrinking public-debt pile.
Two ways out suggest themselves. First, the ECB could buy fewer bonds each
month. But any hint that QE might taper off could cause bond yields in peripheral
countries to jump. A likelier course, then, is to raise the limit to, say, 50% for each
country and for most bond issues.
Even a looser limit will pinch at some point. Economists at Goldman Sachs reckon
the ECB will eventually have to ditch the capital key and buy proportionately more
Italian bonds and fewer German ones. Whatever it takes, is the pledge. No one
believes endless bond purchases will solve the euro zones deep-seated problems.
But no one wants another crisis.