Global
QExit or QEntry?
May 21, 2010

By Manoj Pradhan | London

The ECB's recent decision to purchase debt securities in order to ease market ‘dysfunction' has certainly had the desired impact on bond yields, but it has also left many questions unanswered. Do the bond purchases represent QE or a move towards QE? What does the sterilisation via term deposits mean for the success of the programme? Since the Fed conducted large-scale purchases of assets, can we look to the Fed's balance sheet for more insight into the ECB's balance sheet? In today's lead piece, we take a closer look at these questions, with insights from our euro area and US economics teams (full notes follow this one).

The short answers are: (i) Bond purchases do not represent QE if the sterilisation operations will mean that excess reserves (ER) do not rise (which is the case at the ECB) - but that will not keep the balance sheet (b/s) from rising; (ii) Sterilising bond purchases also implies that the current stance of monetary policy will not be affected. However, the future stance of monetary policy could be looser than the central bank intends due to expansion of the b/s; (iii) While the b/s of the Fed and the ECB are of a roughly similar size and have both expanded because of QE, a comparison between the two is very difficult. The Fed's b/s originally rose because of ‘passive QE', and then maintained its size due to ‘active QE'. The ECB's b/s on the other hand, grew throughout primarily because of passive QE. This makes the ECB's strategy less risky as passive QE is likely to be much easier to unwind than active QE, in our opinion.

In elaborating on our questions for today, we work backwards, starting from a comparison between QE at the Fed and the ECB.

QE at the Fed and the ECB: QE at the Fed and the ECB started at the same time and in the same way. In September 2008, the Fed and the ECB (along with the BoE, the SNB, the Norges Bank and the Riksbank) allowed or encouraged their b/s and ER to expand.  These increases were driven by the financing provided by central banks against securities whose host markets had stopped functioning or were under severe stress. We call this strategy ‘passive QE' because it was financial institutions (rather than the central bank) that decided how much funding was needed, and therefore also decided how much ER and the central bank's b/s would rise by. Since those early months, the Fed's and ECB's b/s have stayed at elevated levels for very different reasons. In early 2009, the Fed adopted ‘active QE' - large-scale purchase of assets which put the expansion of the b/s directly under the control of the Fed. The US$1.725 trillion of assets purchased by the Fed was responsible for the Fed's b/s staying elevated even as passive QE programmes were unwound. On the other hand, the ECB's balance sheet has continued to expand due to passive QE - specifically due to its unsterilised, full allotment refinancing operations. These operations give borrowing institutions as much liquidity as they desire, and therefore put the size of the ECB's balance sheet in the hands of borrowing institutions. 

Sterilisation at the Fed and the ECB: Sterilisation refers to operations that seek to neutralise the impact of asset purchases on ER and/or the b/s. In order to sterilise its asset purchases, the central bank can either sell existing assets or increase its liabilities. A sale of existing assets can exactly offset the asset purchases and thereby bring ER and the size of the b/s back to the original level. Alternately, the central bank can increase select liabilities (e.g., reverse repos or term deposits) in order to sterilise. This would create a shift of liabilities out of ER and into reverse repos or term deposits - a change in the composition of liabilities but not a reduction in the size of the b/s. At the Fed, sterilisation is in progress via the supplemental financing programme (SFP) and will likely be ramped up through reverse repos and term deposits. In yesterday's operations, the ECB used term deposits to drain €16.5 billion from ER. Operations at both central banks constitute sterilisation by an increase in liabilities, so that the overall size of the b/s is not affected.

Different objectives... At the Fed, sterilisation operations have been initiated because the size of ER is massive and the Fed will need some time to drain them. At the ECB, the objective has been to neutralise the impact of recent bond purchases on ER, thereby signalling that the SMP does not constitute a change in the stance of current monetary policy.

In the US as well as the euro area, large ER have reduced the demand for overnight funds and increased their supply, pushing overnight rates lower. Draining reserves is essential if some of this downward pressure on front-end rates is to be reduced as a precursor to rate hikes. Even though our US team expects a first hike in policy rates only in 1Q11, draining US$1 trillion of ER is no easy task and it is no wonder that the Fed wants to make an early start to the process. On the other hand, the ECB's objective in draining ER seems to be aimed at specifically telling markets that its bond purchase programme is closer in spirit to credit easing than quantitative easing, i.e., it has the objective of restoring ‘normal' market functioning and reducing stress rather than providing outright monetary stimulus through permanent injections of money. We believe that such a pointed message to markets is indeed the intention because the bond purchases, at their current size, are too small relative to the ECB's b/s and to its refinancing operations to create a large impact on ER or the b/s. Importantly, the ECB's refinancing operations are not sterilised, and allow commercial banks to keep pushing the ECB's balance sheet and excess reserves higher thanks to full allotment.

...but similar outcomes: The sterilisation programmes at the Fed and the ECB will most probably succeed in reducing ER to levels that the central bank is comfortable with. At the Fed, this will reduce the pressure on overnight rates when ER fall enough, giving the central bank more flexibility in controlling front-end rates. At the ECB, sterilisation is being restricted to the bond purchase programme, so that its effect on the overall level of ER and the current monetary policy stance is neutralised.

QExit or QEntry? Are central banks moving away from QE or towards it? While sovereign credit risk has likely moved the Fed to stay on hold for longer, it continues to move closer to an exit from QE (with the exception of the recently reinstituted FX swap lines). On the other hand, events of the last few weeks have clearly moved the ECB closer towards conducting ‘active QE' along the lines of the Fed or the BoE. Its actions through the SMP so far are very small, easy to sterilise and do not constitute QE or a change in the current monetary policy stance. Indeed, because the ECB's b/s has ballooned largely because of passive QE, the expansion will be relatively easier to reverse as the refinancing programmes are reduced in size or wound down. The Fed, on the other hand, will be able to engineer a permanent reduction in its b/s only by selling assets, a strategy that our US team thinks has wide acceptance at the Fed but is likely to provide quite a bumpy ride.

QExit risks: The sterilisation underway at the ECB (and at the Fed as well) leads to a change in the composition of liabilities and not in the size of the b/s. Further, these sterilisation programmes all solicit rather than force participation from banks, and all return cash to the commercial bank on maturity. Even if excess reserves were to be driven to minimal levels, commercial banks would therefore continue to have access to a large pool of liquid assets (T-bills, and cash due from reverse repos and term deposits on maturity) as a result of the liquidity pushed into the system during the process of expanding the balance sheet. The risk is that these funds could slowly find their way out of the sterilisation operations and into the real economy when economic recovery becomes sustainable and borrowers and lenders return in full force to the market. Thus, it is the future stance of monetary policy that is at risk of becoming looser than central banks would like, even if the current stance remains unaltered by bond purchases. By itself, this skews the balance of inflation risks upwards.