THE ECB'S ROCK AND HARD PLACE - Article by State Street Bank

+ THE ECB'S ROCK AND HARD PLACE ++ - Article by State Street Bank

Morning,

A timely note from our strategist Lee Ferridge around the dangers the ECB
face later today if they decide to inject further stimulus via quantitative
easing -

There is much market speculation that the European Central Bank will on
Thursday announce a quantitative easing programme designed to purchase
Greek government bonds and hence, reduce both pressure on Greece and help
to fight the contagion that has gripped European markets (and those further
afield) in recent days. While it can be argued that the Fed's QE programme
of 2009 and early 2010 (and, to a lesser extent, that of the Bank of
England) proved successful in heading off the "great depression" risk
following the bursting of the credit bubble, the dilemma facing the ECB is
entirely different.

The Fed's QE programme was designed to stimulate the domestic economy
further when traditional monetary policy (i.e. interest rates) had reached
their lower bound (i.e. zero). No more stimulus could be provided at the
short-end of the curve and hence, money was printed in order to buy
government bonds and thereby reduce rates at the longer-end (which is what
QE effectively does).

However, if the ECB were to QE now, it would not be because monetary policy
had reached its lower bound, while EUR 2-yr swap rates yesterday reached
record lows. Rather any ECB QE programme would be started simply because
there are no buyers of Greek government debt – i.e. the ECB would be
monetizing the fiscal deficit; printing money to finance a fiscal policy
that has lost market credibility; the Zimbabwe scenario. Printing money to
overcome the lower bound of monetary policy and printing money in order to
fund government debt is a subtle, but extremely important distinction.
Monetising fiscal mistakes risks further undermining confidence in European
government debt, leading to even higher longer-term rates and hence, more
money printing.

Not only this, but both ECB independence and, the supposed separation of
fiscal and monetary policy would also be thrown into question by such an
announcement on Thursday. The Fed and BoE faced similar risks in 2009 but,
given the alternative of the great depression and lost decade they were
given the benefit of the doubt by the market. The ECB faces an entirely
different set of circumstances and hence, if it uses its "nuclear option"
on Thursday any relief for the euro is likely to be short-lived; a matter
of days (or even hours), rather than weeks. Of course, with no such
announcement Thursday there will be no relief for the euro; a further
widening in periphery bond spreads and a fresh euro sell-off will ensue.
The rock and the hard place – make your choice Mr Trichet. Either way, the
outlook for the euro remains bleak