Long-term yield targeting, an innovative move now adopted by the Bank of Japan, would solve many of the European Central Bank’s own problems but would probably raise even more, making the policy difficult to emulate.
Focusing on keeping the long end of the yield curve stable – around zero percent in Japan’s case – would protect bank margins, take pressure off the ECB to buy a preset volume of assets, and reassure markets that there is an effective floor under bonds.
That would make monetary policy more predictable for banks that transmit policy measures to the economy.
This might, on the face of it, seem attractive to the ECB.
With inflation still well short of the bank’s 2 percent target, the ECB is under pressure to add even more stimulus to its 1.74 trillion euros worth of asset buys, ultra cheap bank loans and deeply negative rates to boost a struggling economy.
But any further stimulus would push the ECB against one of its many self imposed limits, requiring a number of changes that will likely face varying degree of opposition from the hawks within the Governing Council.
“The BOJ’s move is interesting and innovative but the euro zone doesn’t have a single sovereign debt market, it has 19, so such a move would be difficult and get the ECB into hot water,” Berenberg economist Holger Schmieding said. “What yield would you even target?
“This is far too complex to be worth it and it’s a lot of political hassle, raising deep economic questions, yielding dubious benefits,” Schmieding added.
One of the ECB’s problems is that much of German debt yields less than the minus 0.4 percent deposit rate, making them ineligible for asset buys. This raises the chance that the ECB will run out of paper to buy in the bloc’s biggest and best performing economy, especially if the scheme is extended beyond its March 2017 end date, as expected by markets.
Japan-style yield-targeting would let the ECB focus on underperforming papers but risked opening a legal can of worms, analysts said.
It would mean abandoning the so-called capital key, which requires the ECB to buy assets in line with the size of the euro zone economies. And it would mean having to help out a euro zone member coming under market pressure, in the worst case, facing a default.
“The ECB is extremely flexible and they’ve done a lot of things we couldn’t even think of,” Commerzbank Chief EconomistJoerg Kraemer said. “But they are also very reluctant to cross legal red lines.”
“If yields of a country blow out, the ECB would have to do close to unlimited buys,” Kraemer said.
Relying on untested tools, the ECB is already deep in uncharted waters and policymakers have a range of easier options to consider before having to radically alter policy.
The bank is also aware of the legal dangers. Its Outright Monetary Transactions, a never-used emergency bond buying scheme, spent years in the courts before getting the green light, and any radical move that even hints at exceeding the bank’s mandate, would face a challenge.
Still, given that the ECB is many years from getting back to its target, a more fundamental change in its approach is possible and the BOJ move is likely to be scrutinized for clues.
“Could yield targeting thus be an option for the ECB, too?,” RBC Capital Markets said. “We cannot rule this out.”
“As we have argued before that it is predominantly the peripheral markets that are struggling, it would be interesting to see if such a yield targeting was feasible on the higher yielding assets, too,” it added.