The world will be watching closely as the results of this week’s European Central Bank (ECB) monetary policy meeting are released on Thursday. Draghi is keen to avoid under-delivering as he did in December. While he might not again under-deliver relative to market expectations, Draghi—wanting to avoid political turmoil surrounding the legality of the ECB’s actions—will likely underperform relative to what is necessary for quantitative easing (QE) to have a noteworthy effect in the eurozone.
What he should do
Draghi should ditch the requirement that ECB purchases are done in proportion to each eurozone member’s “capital key”—essentially, each member’s relative economic size. As continuing such a policy will likely see the ECB run out of German bonds to purchase before the program’s currently-scheduled end-date, and as the ECB should be focusing on swapping reserves for risk assets, purchases should be weighted more towards the debt of the eurozone periphery countries that are still facing positive yields. While this would face a legal hurdle as it would appear to be the financing of governments, given the still-significant home bias with respect to sovereign bonds, Draghi could likely sell such a policy under the umbrella goal of “one monetary policy” for the eurozone as a whole—bringing yields in line with each other across the eurozone to reduce asymmetries in the recovery. As another means to buying more risk assets, Draghi should expand purchases in the securitization markets (which would also help jumpstart those markets which are still weak following securitization’s role in the financial crisis). This would help free up bank balance sheets and allow them to boost lending to the real economy. (Also on this note, Draghi could seek to by non-performing loans or securitized versions of such, but this would be significantly more politically unpalatable than the above suggestions).
What he likely will do
Given the current rule that QE purchases cannot include bonds yielding lower than the ECB’s deposit rate (now at negative 30 basis points), it is increasingly likely that Draghi will institute a tiered deposit rate system like that instituted in Japan. This will allow Draghi to cut the “headline” deposit rate further—meaning the rate for the tier for new reserves—than he would be able to in an untiered system given recent concerns over the health of banks in eurozone in a negative rate environment. Thus, Draghi will be able to exempt banks from having to pay the new, steeper negative rate on most of their reserves while also being able to increase the quantity of bonds that fit the criterion of yielding more than the ECB’s deposit rate.
It appears that this would be a lot of flash and little substance—much like how the Bank of Japan’s recent shift into negative territory was perceived. It’s likely that the best he’ll provide is some expansion of the purchases of asset-backed securities combined with the tier system mentioned above and the additional bond purchases it enables. However, consistent with the theme of the eurozone’s QE journey so far, it will be too little, too late.