Sunday, September 14, 2014

ECB: QE or QT (Quantitative Tightening)?

Charles Wyplosz at VoxEU questions the potential effectiveness of quantitative easing (QE) as recently announced by the ECB. His main concern is that the ECB version of QE is supply driven, as opposed to the one implemented by the other central banks which is demand driven.

In the case of the US Federal Reserve or the Bank of England, the central bank buys securities and those securities permanently increase the size of the bank's balance sheet. Liquidity is provided regardless of the actions of commercial banks. In contrast, the ECB so far had always relied on the demand from commercial banks for liquidity. The ECB made loans available to commercial banks, and as long as commercial banks demanded those loans, the balance sheet of the central bank also increased (with the deposits of commercial banks being the liability that appears on the other side). But this means that in many ways commercial banks are driving QE. It is their desire to hold more liquidity the one that determines the expansion (or contraction) in the size of the ECB balance sheet.

To understand these dynamics, here are some charts from the ECB web site. First the total size of the balance sheet of the ECB.

We can see several steps after 2008 that increased the size of the ECB balance sheet to about 3 trillion Euros. But we can also see that since 2013, the balance sheet has decreased by more than 1 trillion euros (and no one noticed, by the way). What was he ECB doing? Not much. This is simply the outcome of commercial banks returning the loans that they have gotten earlier from the ECB. Here is the chart with those loans ("lending related to monetary policy operations").

And remember that these loans had to be sitting somewhere else on the liability side of the ECB, they appear as deposits of commercial banks (reserves). Here are the balances of the two accounts where these funds are held (current account and deposit facility).

The pattern of the four charts is very clear: the availability of liquidity by the ECB led to a very large amount of loans being demanded by commercial banks. This increased the size of the balance sheet and the deposits of commercial banks on the ECB. This liquidity had limited effect on lending to the private sector (although it probably protected the financial sector from an even-larger crisis). But as economic conditions stabilized or improved, commercial banks saw no need to hold such large amounts of liquidity so they simply paid back the loans to the central bank. The fact that interest rates on these deposits are now negative led to an acceleration of this trend. So the actions of the central banks (such as negative interest rates on banks' deposits) are not creating an incentive for commercial banks to lend, they are simply creating an incentive for the liquidity that the ECB created to decrease substantially (reverse QE!).

In the last months the ECB has tried to be more aggressive, first with the launch of targeted long term refinancing operations (TLTRO) back in June. But the details of this plan are still unclear (does anyone remember it?)  plus it relies once again on the willingness of commercial banks to lend to the private sector and finance this lending via the central bank. But we just saw commercial banks returning all the liquidity that they had previously borrowed from the ECB. Why will the ask for more?

In the last meeting, the ECB announced a change in strategy with the plan to purchase asset-backed securities. While in some sense this is the first time where the ECB will engage in supply-driven QE (no loans associated to these purchases), the wording of the plan has left many questions open about the extent to which this is a "permanent-enough" commitment to increase the ECB balance sheet and, in addition, the potential volume of these purchases could be small. Small enough that they will not be compensating the fall in the ECB balance sheet that we have witnessed in the last year.

Unfortunately, the ECB is likely to face soon the same question it has faced over the last years: what is next?

Antonio Fatás