The Eurozone is very much expecting some further monetary stimulus. Whether it’s July, September or later remains to be seen, but both the timing and the quantum will be key. Whilst a deposit rate cut is firmly on the cards, the size of potential bond purchases is up for debate.
How much should the ECB spend? We believe €6.75trillion should do it! This is a throwaway number – the ECB couldn’t buy that many bonds even if it wanted to, as there aren’t enough bonds available in practice to buy.
However, to illustrate some of the current funk for central bankers, the ECB (like the Bank of England) still has a 2% inflation target. The Governing Council clarified in 2003 that “in the pursuit of price stability it aims to maintain inflation rates below, but close to, 2% over the medium term”. 2003 now seems like ancient history, with the current rate 0.75% below this target at 1.25%.
So how did we arrive at €6.75trillion? Our government bond team spied a very sensible piece of research by Credit Agricole. They used various in-house models that looked at wages, employment, growth, currency and many other factors; they figured that an 18 month bond purchase programme of €50bn would increase core European inflation by 0.1%. So we figure that if the ECB wanted to achieve its 2% inflation target and aimed to do it solely by bond purchases, then to increase the Eurozone rate from its current 1.25, it would need to buy €375bn a month or €6.75trillion over 18 months.
This is, of course, fanciful and will not happen. But what it does illustrate is the stretched situation that monetary policy is in. For Europe, the debate is set to drift. Effective stimulus needs both monetary policy and fiscal policy. Whilst it is still early days for a sea change, the Italian Prime Minister Giuseppe Conte has already asked the EU commission to review finance rules governing the EU. We now have former French finance minister Christine Lagarde taking over from Mario Draghi at the ECB. Current market valuations leave no room for fiscal policy to not be part of the overall solution.