The big idea out of Europe this week has been that the ECB is finally coming around to engage in bond-buying of troubled eurozone countries in order to force interest rates down and thereby stabilise funding costs for states like Spain and Italy.A few commentators, like PIMCO CEO Mohamed El-Erian, have pointed out the flaws with this approach – namely, that it commits the ECB to unlimited intervention, which could be extremely problematic for financial stability if things don’t eventually turn up in Europe.
Goldman Sachs economist Huw Pill has a bit of an inside perspective on the situation. He’s only been with the firm for about a year now – as early as last summer, he was actually working for the ECB as the head of the Monetary Policy Stance Division within the Bank, where his job responsibilities included preparing both decisions on interest rates and the communication of the Bank’s monetary policy stance to the public.
Pill agrees with El-Erian and other sceptics that the ECB won’t go for spread targeting because of the open-ended commitment it implies and the unwanted moral hazard that could make debt markets even worse.
The ex-ECB economist thinks the Bank has a better idea in mind. In a note to clients, he writes that the ECB, instead of making a commitment to a certain yield target on sovereign bonds, will instead announce a range it deems appropriate for those yields and then opportunistically “support and amplify market movements that it sees as moving yields towards the levels it sees as consistent with fundamentals.”
This will allow the ECB to remain much more nimble and ostensibly shirk the extra risk of yield targeting.
Here’s Pill’s explanation of the plan:
The objective would be to develop a better framework for steering short-dated government bond yields towards levels deemed consistent with fundamentals, while avoiding the creation of a ‘one way bet’ situation that can be exploited by markets. This is likely to be achieved by offering more explicit guidance on where peripheral short-dated yields should lie given the state of macroeconomic fundamentals.
To steer market rates towards that level, we expect the ECB to intervene opportunistically in the one- to three-year maturities in the manner of FX intervention, rather than announce ex ante mechanical intervention rules in the style of exchange rate target zones. In our view, such measures can be effective in preventing the periodic spikes in short-term peripheral government yields that have paralysed markets on various occasions in the past few months.
This all may be cleared up on September 6th at the next ECB meeting, says Pill:
As Mr. Draghi emphasised at his August press conference, the timing of such interventions remains dependent on peripheral governments making a request for support to the EFSF / ESM and accepting the implied conditionality. We continue to see Spain as first in line in that respect, but do not expect a request to be made until mid-September at the earliest. Indeed, the Spanish authorities are likely to wait until they see what is offered by the ECB by way of potential support at the September 6 Governing Council before deciding whether to make a further request for EFSF support and, if so, at what time and in what manner.
Spain said over the weekend that it refused to ask for a bailout until the ECB gave more details on its plan.
So, Pill’s vision of what could happen in the next few weeks seems reasonably attuned to past behaviour by European policymakers. It’s not a “magic bullet” to end the crisis in the eurozone, but it could keep market pressures at bay for a while longer.
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