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Central Bank Policy, Euro Bonds, and QE3.

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    August 22, 2011

    Developments the last few weeks have significantly changed the monetary policy landscape in both the US and EU.  The Fed has committed to holding its target federal funds rate between 0 and .25 percent through mid-2013 and to continue reinvesting principal payments from its existing security holdings.  The ECB has accelerated its purchases of sovereign debt, especially that of fiscally challenged member nations.  This commentary briefly explores the implications of these policy changes for the financial stability of both the US and EU.


    In order for the  FOMC to keep the funds rate within the desired range, it will have to purchase whatever government debt exists or is issued into the market.  This amounts to establishing a de facto QE3 policy without announcing ex ante the amount of securities it intends to purchase.  Instead, the amounts purchased will be “whatever it takes.”  The commitment meshes nicely with the new plans currently being floated by the administration to provide another round of stimulus spending, paired with tax cuts.  Since the government would have to issue even more debt to make up the difference between the new spending and revenues collected, and up the debt ceiling, this would put upward pressure on interest rates, were it not for the Fed’s commitment to keep rates low through the 2012 election and into 2013.


    This policy is reminiscent of that followed during WWII.  At the request of the Treasury, the Fed pegged the rate on three-month Treasury bills at .38% and also, while it was not an announced policy, pegged the rate on 25-year bonds at 2.5%.  By doing so, the Fed gave up control of both the money supply and the size of its balance sheet.  The Treasury-Federal Reserve Accord of 1951 re-established the FOMC’s independent role in setting monetary policy.


    This time, however, there will be no WWII-type wage and price controls or public patriotism to help blunt whatever inflation pressures might emerge.  The Fed will have to rely upon raising the rate it pays on excess reserves to sterilize any tendency for the money supply to increase, and/or increasing the required reserve ratio.  However, raising the rate on excess reserves (or increasing reserve requirements) has its own issues, since there is also a desire to incent banks to begin lending in order to foster economic growth.  Some economists have recently called for cuts in the rate paid on excess reserves, not increases, in order to stimulate more bank lending.


    Thus, balancing the potential inflation tradeoffs against the desire to stimulate lending will require judicious manipulation of the rate paid on excess reserves, at a time when the Fed has no experience with use of that policy instrument, nor a clear view of its link to the inflation and growth channels.  We have entered a new short-term policy regime in which monetary policy is again the servant of fiscal policy and thus places the Fed on a collision course with Republican presidential hopefuls, some of whom have expressed strong opinions on further increases in the Fed’s balance sheet.


    Equally interesting is the path taken by the ECB.  Government officials have begun discussing the desirability of selling euro bonds, apparently not realizing that they essentially already exist in the form of ECB short-term debt.  How could that be?  The answer lies in the fact that the ECB has been making loans to troubled EU banks and has expanded its purchases of risky sovereign debt.  These loans and purchases have been funded by monetizing the loans and debts, using its own less-risky liabilities in the form of interest-bearing term deposits issued to commercial banks.


    ECB assets have increased to €2.07 trillion, which is just shy of their all-time high in June of 2010 and are on a path to mover higher.  This is against a capital base of €81 billion.  Approximately €550 billion of assets are in the form of lending to financial institutions that are significantly exposed to sovereign debt within the EU, and approximately €500 billion are in the form of sovereign debt securities of EU member nations.  A recent study by Ruparel and Persson (June 2011, “A House Built on Sand?: The ECB and the Hidden Cost of Saving the Euro,” http://www.openeurope.org.uk/research/ecbandtheeuro.pdf) estimates that the ECB’s net loss exposure to Greece alone is between €44.5 billion and €65.8 billion, and its exposure to the PIIGS is about €444 billion.


    What would happen to the value of ECB term-deposit debt if a significant portion of the sovereign debt recently purchased should go into default, banks fail, and the losses deplete its capital?  Since there is no central fiscal taxing authority, provisions in the establishment of the ECB call for a draw on the member central banks to replenish the ECB’s capital according to a formula based upon GDP and population.  Should the member central banks not be able to meet their commitments, then they would be forced to go to their treasuries for support.  This certainly looks like a back-door de facto taxing authority and a guarantee of ECB deposits by the member states.


    When one thinks through the implications of what the ECB is doing, it becomes apparent that a breakup of the European Union appears less and less likely.  First, consider what happens if one of the troubled countries decides to leave the EU as a means to solve its fiscal problems.  It would be able to issue its own currency, but this would not solve its problem.  It would still have debt denominated in euros, and devaluation would only up the real cost of that obligation.  If it then defaulted, it would see both a further decline in the value of its currency and a huge increase in its borrowing costs relative to its current costs.  The economic and political consequences would be devastating to any weak country that exited.  The alternative is to stay in the EU and hope for concessions and support from the other member countries, which seems to be what is happening.


    At the same time, the larger  EU members also have a strong short-term economic incentive to ensure that the EU stays together and that member countries don’t leave or default on their debt.  The main reason is that the remaining countries would have to eat the losses that would accrue, both to their banks, which are significantly exposed to troubled EU nations, and to the ECB because of the funding arrangements that were put in place when the ECB was established.  The point is that the more sovereign debt the ECB purchases and monetizes by issuing its own deposit debt, the more the healthy member states are obligated to absorb losses.


    The EU seems to be digging a hole that is getting deeper and deeper and potentially ever more onerous for the larger and more prosperous member nations.  This realization is clearly what is behind the calls this week by France and Germany to require member nations to establish balanced-budget requirements and to establish a Eurozone “government,” with a president empowered to overrule national governments.  This proposal, while likely to be perceived as onerous to weaker states, may be the only way out for countries whose fiscal policies are not in balance.


    Putting the changes in Fed and ECB policies decisions together suggests that the US is on a road to looking more and more like Europe, with its bloated governments and fiscal deficits.  The consequences of failing to address the debt problems now only loom larger in the future.  At the same time, the EU is evolving into a structure that more closely resembles that of the US, with a stronger federal government, a federal fiscal authority, and balanced-budget requirements at the state level.  Where the two will meet isn’t clear, but the present paths are unsustainable.

    Cumberland Advisors – Market Commentary.

    Images: Flickr (licence/attribution)

    About The Author

    Dr. Robert A. Eisenbeis serves as Cumberland Advisors’ Chief Monetary Economist. In this capacity, he advises Cumberland’s asset managers on developments in US financial markets, the domestic economy and their implications for investment and trading strategies.

    Dr. Eisenbeis was formerly Executive Vice-President and Director of Research at the Federal Reserve Bank of Atlanta, where he advised the bank’s president on monetary policy for FOMC deliberations and was in charge of basic research and policy analysis. Prior to that, he was the Wachovia Professor of Banking at the Kenan-Flagler School of Business at the University of North Carolina at Chapel Hill. He has also held senior positions at the Federal Reserve Board and FDIC.

    He is currently a member of the Shadow Financial Regulatory Committee and Financial Economist Roundtable and a fellow member of both the National Association of Business Economics and Wharton Financial Institutions Center. He holds a Ph.D. and M.S. degree from the University of Wisconsin and a B.S. degree from Brown University.