Mario Draghi, the ECB's president, promises to do "whatever it takes" to boost inflation expectations, but this rhetoric is increasingly at odds with their self-imposed constraints. The rulebook for quantitative easing (i.e. bond-buying) inside the single currency is quite complicated. The ECB have set themselves a numbers of restrictions as follows:
The ECB will not buy
(1) Bonds of less than 2 years or more than 30 years in maturity.
(2) Bonds with a yield less than their deposit rate (currently -40bp).
(3) More than 25% of any specific issue with a collective action clause (CAC).
(4) More than 33% of any specific issue without a collective action clause.
The ECB will
(5) buy bonds in accordance with its capital key (i.e. buying fixed relative amounts of German/Spanish/Italian/French/etc. debt).
These rules make it increasingly difficult to sustain the purchase of €80bn of euro zone debt every month. Despite these debt purchases (and having interest rates well below zero), the ECB is struggling to convince investors that they can sustain inflation close to their target: the flagship measure of market inflation expectations has dropped to an all-time low of 1.3%.
The binding factor that prevents the ECB from doing more is the German bond market. With German yields so depressed, they are forced into steadily increasing the maturity of their German debt purchases to meet criterion (2). With the government in Berlin running a fiscal surplus, the amount of German debt outstanding is decreasing and they are struggling to satisfy criteria (3) and (4).
So, what is likely to change in the ECB's set of self-imposed constraints, and with what consequences?
Unfortunately, there are no particularly good options at this stage. The easy things to do will not materially increase the eligible asset poll and will only buy the ECB a few additional months. Given the institution’s history of incrementalism, these are likely to be tried first. The era of ultra-low German government bond yields looks set to continue.
The really big decisions (abandoning the yield floor or the capital key) are much harder for the Governing Council to sign off. In principle, they are willing to do “whatever it takes” to drive up inflation. In practice, this resolve is being constantly tested.