Extremely low yields and a potential shortage of bonds prevent the monetary transmission mechanism to function properly in the Eurozone.
The ECB Governing Council is set to meet on July 21st. Once again, the main question for the institution will be about what can be done to drive Eurozone back to growth and avoid deflation. As repeatedly stated by Mario Draghi and his colleagues, the monetary policy has its own limits and needs to be supported by structural reforms. In an environment where both conventional and unconventional tools have been used and as further easing could prove relatively inefficient, the answer must come from European governments and the EU itself.
After the Brexit vote and as euro-scepticism grows all over Europe, now is the right time for a wake-up call for the EU to take the reforms needed and for the monetary policy not to be the only expansionary policy in the Eurozone anymore.
Limits Of Monetary Policy
The ECB has supported the financial system and the global economy in the Eurozone with a very accommodative monetary policy in recent years. In March, the ECB cut its main rate to 0% and its deposit rate to -0.40% and increased its Quantitative Easing (QE) programme to €80bn of bonds purchases per month. The ECB also started to buy European corporate bonds along with government bonds in June.
This monetary policy is supposed to boost investment and support economic growth. However, expectations of long-term uncertainty and acceptance of a new normal environment of low yields hamper its efficiency.
by the ECB monthly
A fully working transmission mechanism should see the injection of liquidity by the ECB to the banking system being multiplied and relayed to the real economy. What one can see today, however, is that banks are increasing their reserves of liquidity but are not able to fuel the real economy. This lack of transmission is mainly due to regulatory constraints and risk aversion from banks and from the private sector. Even though the ECB gave banks an incentive to lend more to non-financial institutions, the global demand for credit remains very low as global economic uncertainty weighs on investment decisions.
Adjustments To The QE
Abundant liquidity in the market, combined with this lack of transmission to the real economy pushed government bonds to record low yields. The ten-year German bund trades consistently in negative territory sometimes joined by Finnish and Dutch bonds. Negative yields are now widely spread across the Eurozone in short end bonds.
This is a massive problem for the ECB as, in its current form, the institution cannot buy bonds that yield below the deposit rate and more than €800bn of German Bunds trade below this level of -0.40%. Under the capital key rule that takes into account the proportion of each country’s shareholding in the ECB, German bonds have to represent close to 18% of the purchase programme. There is then a potential shortage of bonds that fuels investors’ appetite for all eligible bonds and pushes yields further down.
The ECB will face difficult questions about possible adjustments to the QE, mainly to avoid the risk of a shortage of bonds. Another cut of the deposit rate might fuel further the rally in bonds and abandoning the capital key rule could be politically risky and especially unwelcome by the German Federal Court in Karlsruhe.
In the meantime, this spiral of low to negative yields weighs on the banking system. As ECB Vice-president Vitor Constancio recently stated: “A key cyclical challenge is linked to the difficulties in increasing revenues in a low nominal growth and low-interest rate environment and a flat yield curve”.