Observations on Yellen's Speech Yesterday

In light of Yellen’s speech yesterday on Inflation Dynamics and Monetary Policy, I thought I’d offer a few comments that I believe are receiving insufficient attention in the financial press.

First, when asked at last week’s press conference about the timing of the anticipated rate hike, Yellen noted that "most [FOMC] participants continued to think that economic conditions will call for or make appropriate an increase in the federal funds rate by the end of this year" – a view she reiterated in her comments yesterday. But if she had been asked at the press conference for the date she expected financial conditions to tighten, she would have answered, ‘They just did.’ More precisely, in her introductory remarks at the press conference she said, "Developments since our July meeting—including the drop in equity prices, the further appreciation of the dollar, and a widening in risk spreads—have tightened overall financial conditions to some extent. These developments may restrain U.S. economic activity somewhat and are likely to put further downward pressure on inflation in the near term." This perceived tightening of financial conditions weakened the argument for a hike at this month’s meeting, and we should expect FOMC members to incorporate their perceptions of subsequent financial conditions as they consider policy options at the October and December meetings.

Second, some FOMC members may be more comfortable raising rates once they have greater confidence in the technical capabilities of their new policy tools to ensure that money market rates in general increase with the IOER. In particular, the Fed’s open market desk is running term repo programs across the Q3 and Q4 quarter-ends at the instruction of the FOMC "…to examine how term RRP operations might work as an additional supplementary tool to help control the federal funds rate." I don’t mean to overemphasize the importance of this factor in their deliberations, but it’s worth keeping in mind that their decision to announce a policy change depends not only on their intentions but also on their perceived capabilities.

Third, in her speech yesterday, Yellen offered her perspective on factors that produce short-term departures of inflation from longer-term expectations. "Economic theory suggests, and empirical analysis confirms, that such deviations of inflation from trend depend partly on the intensity of resource utilization in the economy…" However, she neglected to specify whether “the economy” to which she referred is the US economy, the global economy, or perhaps some subset of the global economy. The considerable correlation between inflation rates in the larger economies suggests resource slack globally is a relevant consideration, with two specific implications. First, it’s not merely slack in the US labor market that is relevant. Slack in foreign labor markets has a direct effect on US labor costs in the markets for tradeable goods and services, as well as an indirect effect on US labor costs in the nontradeable sector, via competition for labor between firms in the tradeables and nontradeables sectors. Second, underutilization of the stock of physical capital globally is also relevant, which is particularly important given ongoing upward revisions in estimates of the amount of underutilized capital stock in China after years of record investment.

Fourth, in her speech yesterday, Yellen argued, "the presence of well-anchored inflation expectations greatly enhances a central bank's ability to pursue both of its objectives--namely, price stability and full employment," since a flat expectations-augmented Phillips curve implies that a large change in employment results in only a small change in inflation. But a high sacrifice ratio also means that a large increase in employment would be required to result in a modest increase in the inflation rate. In forecasting a return of inflation to its 2% target over a reasonable horizon, Yellen is relying on inflation expectations being anchored close to 2%. But as she notes, market-based measures of inflation expectations have declined, with the five-year breakeven rate at 1.11%, now 60 bp off this year’s high; 70 bp below its five-year average; and 89 bp below the Fed’s 2% reference rate. Yellen suggests that the market-based measures may be biased by changes in liquidity and in risk premiums, but she’s aware of the risk that market participants are coming to view below-target inflation as persistent. If the FOMC were confronted with a flat Phillips curve anchored below 2%, even the “gradual pace of tightening” anticipated by most FOMC members would be inconsistent with the return of inflation to target over a relevant policy horizon.

Yellen and her colleagues on the FOMC insist on setting policy appropriate for the US economy rather than for the global economy more generally. But given the interconnectedness of major economies, the FOMC is forced to consider developments outside the US. And given inflation developments in the Eurozone, Japan, the UK, and even China – and given estimates of resource slack in these economies – FOMC members are unlikely to make much progress toward even a modest ‘normalization’ in the next few quarters. And for similar reasons, if Yellen is correct that the Phillips curve is relatively flat, the labor and capital markets globally are likely to have a greater influence in the next few quarters on real rates, inflation, and output developments in the US than will Fed policy.

Ahead of Today's ECB Press Conference

Ahead of the ECB press conference this afternoon, it’s worth reviewing the challenges the ECB faces in its efforts to boost inflation.

The main strategy the ECB is pursuing is to weaken the currency, in an attempt to increase the euro-denominated price of imports into the Eurozone and to lower the prices of Eurozone goods and services denominated in other currencies. The main tactic it’s employing in pursuit of this strategy is to lower its policy rates, widening the interest rate differences between the euro and other currencies.

The first challenge with this approach is that is relies heavily on the notion that exchange rates can be managed by managing interest rate differentials. It’s true that the literature on the uncovered interest rate parity puzzle finds a general tendency for high-yielding currencies to appreciate. But the proposed mechanisms that bring about this correlation are not well understood at a conceptual level, and this literature doesn’t suggest that a central bank can expect to manage the exchange rate via interest rate policy. At a minimum, the experience of the euro over the past month suggests the ECB faces a real challenge in weakening the currency via rate policy.

The second challenge is that the Eurozone isn’t a mid-sized, open economy, like the UK, which experienced an increase in its inflation rate after a depreciation of sterling. As a result, the currency depreciation required to increase the Eurozone inflation rate by, say, 50 bp, is presumably much larger than the depreciation required for a similar increase in the UK inflation rate. To put these moves in perspective, sterling depreciated roughly 30% relative to the dollar in 2008. A similar move in the euro would bring the currency to just below parity against the dollar. With this in mind, it seems highly improbable that a difference in the policy rates of 35 bp will lead to a depreciation of the euro sufficient to produce a noticeable increase in the Eurozone inflation rate.

In the bigger picture, the main potential internal catalysts for growth in the Eurozone are probably fiscal stimulus and labor market reforms. The latter are increasingly unlikely given favorable pricing of peripheral debt currently, while the former are under discussion within the EU but face serious constraints, given the negotiating stance taken by the northern EMU member states.

The potential external catalyst for growth in the Eurozone is an increase in export demand, consistent with the ECB strategy. But I believe an increase in export demand will only take place in an environment of more robust global growth. In particular, I don’t believe the ECB will be able to increase export demand noticeably unless it can engineer a significant currency depreciation. And I don’t believe the ECB will be successful in engineering a significant currency devaluation simply by increasing the policy rate difference with the US by 10 bp.

No doubt Draghi will be asked about his exchange rate strategy at today’s press conference, particularly as the euro has richened back to its level at the time of the June press conference. And no doubt he’ll reiterate that the ECB is prepared to use unconventional instruments, including large-scale asset purchases. And in this regard it’s worth noting Draghi’s comments during the last press conference on the timing of policy changes with respect to persistent low inflation, “…the longer it lasts, the higher the risks. And that's what we are reacting to. We are reacting to a risk of a too-prolonged period of low inflation.”

During the height of the euro sovereign debt crisis, peripheral spreads and the euro were negatively correlated, as the euro weakened in response to higher peripheral spreads. At the moment, I expect this negative correlation will continue, as peripheral spreads narrow in response to any currency strength. In particular, unless the euro weakens or unless global growth increases, the ECB will feel an increasing need to conduct large-scale asset purchases. My expectations for the next few months are that the euro is unlikely to weaken by an amount that would boost inflation noticeably and that global growth is likely to remain modest so that peripheral spreads will continue to narrow as the prospects for large-scale asset purchases increase. But today's press conference will provide another opportunity for assessing the views of the Governing Council on the issue.

Yellen, Employment, and Financial Stability

The two most interesting events for the bond market this week are likely to be Yellen’s IMF speech later today and nonfarm payrolls tomorrow. I’ll discuss each of these two events in turn and then comment on the link between the two.

Yellen's IMF Speech on Financial Stability

The topic of Yellen’s speech, financial stability, is particularly appropriate given the current critique that highly accommodative policies among the big four central banks are resulting in overvaluations in various markets (eg, housing, bonds, credit, equities) and prompting households and firms to take undue risks.

Just this weekend, at the start of the BIS AGM, General Manager Jaime Caruana summarized this critique succinctly. Speaking of the various effects of “extraordinarily accommodative” monetary policy, he noted, “There is a threat to financial stability too, as ultra-low interest rates promote debt accumulation and risk-taking.” And he concluded his comments on monetary policy by suggesting, “After years of easy money, we need to pay more attention to the risks of normalising too late.”

Yellen’s recent comments suggest she’s currently more sanguine about these risks. For example, at the June 18 FOMC press conference,  Greg Ip asked Yellen specifically, “Will financial stability considerations play a role in when and how fast the Committee normalizes interest rates?” Yellen’s response was fairly direct. “I don’t see them shaping monetary policy in an important way right now. I don’t see a broad-based increase in leverage, rapid increase in credit growth or maturity transformation, the kinds of broad trends that would suggest to me that the level of financial stability risks has risen above a moderate level.”

However, the larger discussion among central bankers is about the ways in which financial stability should influence their overall policy frameworks. For example, simple rule-based approaches, such as the Taylor rule, don’t address the issue of financial stability. And yet many central bankers believe there is a political and social imperative post crisis to include financial stability in their policy frameworks. The challenge for each central bank then is to develop a framework that addresses financial stability in a way that reflects its particular mandate.

The most active line of research on this issue within the Fed involves the use of a loss function that penalizes the policy maker for deviations from his mandated objectives. In the quadratic version of this loss function (discussed most frequently at the Fed), the penalty increases as the square of the deviation. For example, if the inflation objective is 2% and the actual inflation rate is 3.5%, the penalty is considered to be 2.25 (ie, [3.5-2]^2 ). The strategy of the policy maker then is to minimize the sum of the expected deviation from target and the expected value of the squared deviation from target (ie, the variance). In the case of the Fed, there would be two targets: inflation, and employment.

The relevant aspect of this approach is that it presents the policy maker with a trade-off between the mean and the variance of the deviations from target. As a result, the policy maker may intentionally follow a policy in which inflation and/or unemployment are expected to deviate from their targeted values if the policy results in a reduction in the variances of these deviations from their targets. Or as Kocherlakota put it in a speech in April of last year, “…the Committee has to weigh the certainty of a costly deviation from its dual mandate objectives against the benefit of reducing the probability of an even larger deviation from those objectives.”

There are quite a number of potential problems in adopting this approach. For example, the Fed would need to have models for inflation and unemployment that specify their variances as well as their expected values. In a speech in March of this year (ie, while still a Board member), Jeremy Stein suggested that bond term premiums and credit spreads would be useful variables in this context. In particular, he suggested, “…monetary policy should be less accommodative--by which I mean that it should be willing to tolerate a larger forecast shortfall of the path of the unemployment rate from its full-employment level--when estimates of risk premiums in the bond market are abnormally low.”

Stein’s comment highlights not only the modelling challenges inherent in the loss function approach but also the political difficulties the Fed is likely to encounter were it to adopt this framework. For example, one can imagine the heated comments Yellen would receive from members of Congress during her semi-annual testimony if she acknowledged that the Fed was intentionally sacrificing the jobs of their constituents because the yield curve was too flat.

An additional economic and political challenge would be to specify an appropriate employment target, which presumably would need to vary over time. And for a Fed so clearly committed to transparency, attempts to communicate policy formulated with a quadratic loss function would pose a considerable challenge.
Given Yellen’s recent comments, I don’t expect her to announce a major shift in the Fed’s framework in today’s IMF speech. But I do believe it’s possible that she’ll provide an update on Fed research into this issue, as part of an evolution in the Fed policy framework, similar to the evolution in the Fed’s specification of a 2% inflation objective under Bernanke.

As for the immediate implications, I expect Yellen will reiterate that the observed degrees of indebtedness and leverage in the economy don’t point to the sorts of financial imbalances that would pose a risk to financial stability. Note that in her recent comments she’s avoided using asset prices per se as a metric for assessing financial stability, preferring instead to focus on the exposures within the household, financial, and corporate sectors.

Thursday's Nonfarm Payrolls Report 

In this context, it’s also worth considering the immediate implications of this week’s payrolls report on Fed policy. The median estimate of economists surveyed by Bloomberg is currently 213 K, with the unemployment rate remaining at 6.3%.  Figures in line with these expectations would be consistent with a continuing decline in the available slack in the labor markets.

But the problem facing the FOMC is not to estimate the pace with which resource slack is declining. Rather, it’s to estimate the point at which the slack will be depleted, at which time increasing labor costs would be expected to exert upward pressure on the inflation rate. And to estimate the level of labor slack (as opposed to its change), one needs to take a view on the effect of quite a number of factors, such as the pace of retirements, hysteresis, and changes to various government programs, such as unemployment, disability, SNAP, and health care.

Given the difficulty of estimating labor slack directly, the Fed also finds it useful to monitor wage developments, given the reasonable expectation that unit labor costs will begin to increase as slack in the labor market is eliminated. For example, during her testimony before the Joint Economic Committee on May 7, Yellen noted, “most measures of labor compensation have been rising slowly--another signal that a substantial amount of slack remains in the labor market.”

Yellen also referenced the unemployment rate and labor costs during the press conference following the June 18 FOMC meeting. On the unemployment rate, she offered, “…many of my colleagues and I would see a portion of the decline in the unemployment rate as perhaps not representing a diminution of slack in the labor market.” And she later noted, “My own expectation is that as the labor market begins to tighten, we will see wage growth pick up … so households are getting a real increase in their take-home pay. She continued, “Within limits, it’s not a threat to inflation…” She then noted, “If we were to fail to see that, frankly, I would worry about downside risk to consumer spending.”

Financial Stability and Employment in the Context of Monetary Policy

As the unemployment rate continues to decline, and as real and financial assets continue to richen, I expect the calls for the FOMC to hike rates will grow louder, including calls from members of the Committee. But I also expect that Yellen will continue to argue that unit labor costs are more useful than the unemployment rate in gauging slack in the labor market and that exposures in the household, financial, and corporate sectors are more important than asset prices in assessing risks to financial stability.

I expect these developments will occur in the context of a continuing trend in the asset markets in which the capital available for investment exceeds the demand for capital to invest, resulting in a general reduction in expected returns across asset markets, consistent with higher equity prices, tighter credit spreads, higher house prices, and lower real yields. But as the inflation hawks become increasingly vocal in H2, I expect we’ll see some upward pressure on the 1Y-5Y segment of the yield curve and upward pressure on longer-dated breakeven inflation rates. I also expect we’ll see greater volatility along the curve in general, particularly in the 1Y-5Y segment.

EFSF Partial Protection Certificates No Panacea

Last night, the Eurogroup announced further details about the two mechanisms through which the EFSF is to provide assistance to troubled sovereigns. I'll focus on the Partial Protection Certificates in this post and discuss the Co-Investment Fund in a separate post.

The Eurogroup intends for the EFSF to issue Partial Protection Certificates (PPC) in conjunction with bond issuance for distressed sovereigns. The few available details can be found in the Terms and Conditions document published on 29-Nov-11, but some of the more relevant provisions are troubling.

1. As the name suggests, each PPC will offer only partial protection, from 20-30%, "to be determined in light of market circumstances."
2. Each PPC will be issued by a Luxembourg special purpose vehicle (SPV), which "would not be legally connected to the EFSF or Member States."
3. "The certificate gives rise to a claim in the event of a Member State credit event under the full ISDA definition, which covers (i) failure by the Issuer to make full and timely payments of amounts scheduled to be due in respect of one or more bonds, subject to grace periods; or (ii) repudiation or moratorium;or (iii) restructuring. These losses will be determined based on the ISDA procedures."
4. "The SPV will settle the claim by cash or by EFSF bonds."
5. "...the claim is unfunded until the time of a call.  Upon investors’ request it could be considered, that claims would be funded at the outset."
6. "The investor will be required, at time of claim or settlement, to demonstrate that they hold outstanding sovereign bonds of that Member State of at least the same principal value as the original bond covered by the Certificate."

These terms present some considerable concerns.

First, investors will ask whether the PPCs would have helped the holders of Greek debt. A PPC of 30% in theory places a floor of 30% on the value of a bond. Greek private sector involvement (PSI) has required a "voluntary" contribution of 50% from investors. It appears that a PPC of 20-30% would have been of no use whatsover to a holder of Greek debt.

The Eurogroup would respond to this critique by noting that the PPCs can be detached and traded separately. But the terms and conditions clearly specify that a PPC needs to be re-attached to a bond in order to be redeemed. It appears very likely that Greek bondholders would have been asked to contribute 50% toward Greek assistance irrespective of any PPCs that might have been issued in conjunction with Greek bonds.

Second, the credit quality of the PPCs themselves appear highly questionable. The PPCs are to be issued by an SPV with no legal connection to the EFSF or to Member States and to be unfunded until the time of call. And the PPCs can be settled with EFSF bonds. If Member States fail to fund the SPV at the time of call, or if the SPV otherwise is unable or unwilling to pay on claims, what legal recourse is available to holders of PPCs? And if one of the larger Member States has defaulted or restructured, what value is an EFSF bond likely to have?

And this brings us to the third major concern: a credit event is to be determined by ISDA using standard terms. But in the case of Greece, we've seen that Member States have been able to engineer a 50% restructuring of debt without triggering a credit event as determined by ISDA. If Member States can extract a 50% restructuring without triggering an ISDA credit event, of what use is a PPC whose payoff is determined by ISDA terms?

These concerns are not details to be addressed at some later date. They address the ability of the PPC program to add any credit enhancement whatsoever. My sense is that PPCs as designed are virtually worthless, and I expect most investors will reach a similar conclusion.

Legal Issues of ECB Lending to the IMF

News reports suggest that officials from the ECB and the IMF have been discussing a plan in which the IMF would purchase EMU member state sovereign debt using loans from the ECB. In fact, rallies in the euro and in equities earlier today have been attributed to this story.

This plan would be an unlikely development for a number of reasons, particularly given the legal prohibition against monetary financing of member states by the ECB.

ECB financing and the IMF

As recently, as 9-Nov-11, the ECB issued a legal decision clarifying that a member of the European System of Central Banks (ESCB) could provide monetary financing of a Member State's obligations to the IMF, consistent with Article 7 of Regulation (EC) No 3603/93 issued by the Council of the European Union.

However, the suggestion here is not to provide financing to a Member State to give to the IMF. Rather, the proposal reported today is to providing financing to the IMF to give to Member States. And this is an issue that the ECB already has addressed.

ECB already has ruled out this aproach

The ECB offered a legal decision on 17-Mar-11 in which it stated that lending by the ECB to the ESM would not be consistent with EU Treaties and Statues. To see whether the logic of that decision applies to the IMF, it's useful to carefully consider the relevant two paragraphs in the decision.

"With respect to the role of the ECB and the Eurosystem, while the ECB may act as fiscal agent for the ESM pursuant to Article 21.2 of the Statute of the European System of Central Banks and of the  European Central Bank (hereinafter the ‘Statute of the ESCB’), in the same way as under the Union’s  Medium-Term Financial Assistance Facility, the EFSM and the EFSF, Article 123 TFEU would not  allow the ESM to become a counterparty of the Eurosystem under Article 18 of the Statute of the ESCB.


On this latter element, the ECB recalls that the monetary financing prohibition in Article 123 TFEU is one of the basic pillars of the legal architecture of EMU both for reasons of fiscal discipline of the  Member States and in order to preserve the integrity of the single monetary policy as well as the  independence of the ECB and the Eurosystem."

As mentioned in my last post, Council Regulation (EC) No 3603/93 of 13 December 1993 interprets Article 123 of the Treaty for the Functioning of the European Union (formerly Article 104 of the Maastricht Treaty) so as to preclude monetary financing via third parties. The EU decision applies this logic to the ESM as a third party and concludes that the ECB is not permitted to lend to the ESM. Application of the same legal argument to the IMF would be expected to lead to a similar decision.

The Views of Bundesbank President Weidmann

In fact, Bundesbank President Jens Weidmann addressed this issue directly in an interview published with the Financial Times at the beginning of the week.

FT: Some in Washington have suggested the ECB could lend, directly or indirectly, to the IMF, which could then help Italy. Would you rule that out as a possibility?

JW: Again, the crucial point is that the eurosystem is not permitted to lend to eurozone member states – no matter whether this is done directly or indirectly by using the IMF as an intermediary.

The bottom line

The Treaties, Statutes, Regulations, and Decisions of the EU prohibit monetary financing of Member States, directly and indirectly -- a point reiterated just this week by the President of the Bundesbank. As a result, it seems today's story is a canard -- a trial balloon with the intent by mid-level finance ministry functionaries to find some creative solution to the debt crisis. My sense is that they'll need to keep trying, as this proposal appears very unlikely to be implemented.

Legal Issues Involving the ECB as Sovereign Lender of Last Resort

With plans for the EFSF floundering, there are increasing calls for the ECB to buy large quantities of Italian sovereign debt in an attempt to reduce Italian bond yields and retain Italy’s access to the primary debt market. For example, Portuguese President Anibal Cavaco Silva called last week for the ECB to act as a lender of last resort with a “foreseeable, unlimited intervention.”

While these calls are understandable given the current circumstances, recent indications suggest these calls are falling on deaf ears. Regardless of the various economics arguments for and against the ECB adopting a role as lender of last resort for Member States, there appear to be compelling legal issues arguing against this, beginning with the statute that enabled the European System of Central Banks.

The Statute of the European System of Central Banks (ESCB)

The Statute is a protocol attached to the Maastricht Treaty, agreed in February 1992. Article 18(1) of the Statute permits the ECB and the national central banks of the eurosystem to purchase securities to achieve the objectives of the ESCB, while Article 18(2) gives the ECB the ability to establish principles governing these purchases. These Articles are fairly short and are worth repeating here.

Article 18

Open market and credit operations

18.1. In order to achieve the objectives of the ESCB and to carry out its tasks, the ECB and the national central banks may:

— operate in the financial markets by buying and selling outright (spot and forward) or under repurchase agreement and by lending or borrowing claims and marketable instruments, whether in Community or in non-Community currencies, as well as precious metals;

— conduct credit operations with credit institutions and other market participants, with lending being based on adequate collateral.

18.2. The ECB shall establish general principles for open market and credit operations carried out by itself or the national central banks, including for the announcement of conditions under which they stand ready to enter into such transactions.

It’s worth noting that while Article 18 gives the ECB fairly broad powers to buy and sell securities, it places a constraint on the purpose for which these market transactions can be conducted. In particular, these powers have been granted “in order to achieve the objectives of the ESCB,” which are specified in various documents, including the Maastricht Treaty.

The Maastricht Treaty

The powers granted the ESCB by Article 18 of the Statute are further constrained by Article 104 of the Maastricht Treaty, now article 123 of the Treaty for the Functioning of the European Union (TFEU). The first paragraph of Article 104 prohibits monetary financing of EMU Member States and deserves careful consideration.

Overdraft facilities or any other type of credit facility with the ECB or with the central banks of the Member States (hereinafter referred to as ‘national central banks’) in favour of Community institutions or bodies, central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of Member States shall be prohibited, as shall the purchase directly from them by the ECB or national central banks of debt instruments.

It's important to note that the prohibition in this paragraph is of purchases that are made “directly” from EU sovereigns. The lack of an explicit prohibition against secondary market purchases has been seized upon by those advocating that the ECB act as a lender of last resort for Member States by purchasing significant quantities of sovereign debt in the secondary market. However, secondary market purchases for this purpose appear to be restricted by a regulation issued in 1993 by the Council of the European Union as part of the implementation process for the Maastricht Treaty.

Council Regulation (EC) No 3603/93 of 13 December 1993

In EC No 3603/93, the Council addressed the issue of secondary bond market purchases by clarifying the definition of the phrase, “other type of credit facility” in paragraph 1 of Article 104 of the Maastricht Treaty (Article 123 of the TFEU). The relevant article appears below with the key text highlighted in bold for easier reading.

Article 1

1. For the purposes of Article 104 of the Treaty:

(a) 'overdraft facilities' means any provision of funds to the public sector resulting or likely to result in a debit balance;

(b) 'other type of credit facility' means:

(i) any claim against the public sector existing at 1 January 1994, except for fixed-maturity claims acquired before that date;

(ii) any financing of the public sector's obligations vis-à-vis third parties;

(iii) without prejudice to Article 104 (2) of the Treaty, any transaction with the public sector resulting or likely to result in a claim against that sector.

In its Convergence Report of May 2010, the ECB also addressed this issue. In a section titled, Prohibition on Monetary Financing, the ECB commented on Council Regulation (EC) No 3603/93, noting “the prohibition includes any financing of the public sector’s obligations vis-à-vis third parties.”

Intent matters

The effect of the Maastricht Treaty, the ESCB Statute, and the associated Council Regulation is to permit the ECB to purchase sovereign debt in the secondary market with the intent to “achieve the objectives of the ESCB” but to prohibit secondary market purchases with the intent to provide monetary financing of Member State budgets.

This interpretation appears to be shared by the ECB, as evidenced in various ECB opinions. For example, in a legal opinion dated 25-Mar-10 on independence, confidentiality and the prohibition of monetary financing (CON/2010/25), the ECB indicated, “The prohibition of monetary financing prohibits the direct purchase of public sector debt, but such purchases in the secondary market are allowed, in principle, as long as such secondary market purchases are not used to circumvent the objective of Article 123 of the Treaty.”

And to underscore the importance of these restrictions and its commitment to them, the ECB also wrote in that section, “The monetary financing prohibition is of essential importance to ensuring that the primary objective of monetary policy (namely to maintain price stability) is not impeded. Furthermore, central bank financing of the public sector lessens the pressure for fiscal discipline. Therefore the prohibition must be interpreted extensively in order to ensure its strict application...”

The Securities Market Programme

The ECB has repeatedly stressed the limited and specific purpose of the SMP. For example, in the ECB Decision to establish the SMP, it cited “...severe tensions in certain market segments which are hampering the monetary policy transmission mechanism and thereby the effective conduct of monetary policy oriented towards price stability in the medium term.”

With this in mind, the critical issue at the moment is whether the ECB believes significant purchases of Italian debt would be to enable the effective conduct of monetary policy or to provide monetary financing for a Member State. Reasonable people can and do differ on this issue, at times considerably. For example, Axel Weber, at one point the presumptive successor to President Trichet, and Jürgen Stark, the ECB Chief Economist, were so strongly opposed to the SMP in its current form that they resigned earlier in the year.

With President Trichet having just ended his tenure as ECB President, it’s useful to consider the views of the new President, Mario Draghi.

The views of President Draghi

At his inaugural press conference as ECB President on November 3, Mario Draghi was asked a pointed question by a journalist. “Are you prepared now to make a commitment that you will do whatever is necessary to keep the euro area in one piece, including – if necessary – becoming the lender of last resort to governments?”

Draghi’s response was instructive. “I have a question for you: what makes you think that the ECB becoming the lender of last resort for governments is what is needed to keep the euro area together? No, I do not think that this is really within the remit of the ECB. The remit of the ECB is maintaining price stability over the medium term.”

From this response, it appears Draghi is not inclined to support additional purchases of Italian debt for the purpose of providing monetary financing for Italy. 

The Bottom Line

The clear legal intent at the establishment of the monetary union was to avoid monetary financing of Member State budgets, and President Draghi appears committed to upholding this principle. 

It appears reasonable to expect that moderate purchases of Member State debt will continue for the specific purpose of facilitating the transmission mechanism for monetary policy. But calls for the ECB to contravene the enabling treaties, statutes, regulations, and decisions of the monetary union appear to be falling upon deaf ears. Regardless of any economic arguments to the contrary, the legal issues simply don’t appear consistent with the ECB assuming a lender of last resort function with respect to Member States. If the market refuses to provide additional financing for Italy at some point, it appears the Italians will have to look elsewhere for assistance in financing their budget.

Behind the headlines: smoke and mirrors

The headlines from last night's EU summit are positive, as are reactions in the equity and currency markets, but a careful reading of the EU summit statement gives a more sobering picture.

The 50% figure for private sector involvement (PSI) is large, involuntary, and comes with no greater guarantee of finality than did the 21% figure announced fourteen weeks ago. The structure of the bond exchange has yet to be determined, and we don't know the extent to which various parties will participate. (The presumption is that this level of PSI won't trigger CDS, but I wouldn't be surprised if this view was challenged at some point.)

We're told that credit enhancement will be provided so that Greek collateral will remain eligible for Eurosystem liquidity operations, but we don't know the form this enhancement will take.

We're told that eurozone member states "solemnly reaffirm their inflexible determination to honour fully their own individual sovereign signature." But we're given no reason to expect investors will be treated any better in the future than they're being treated in the case of Greece.

The enhancements to the EFSF "will be done without extending the guarantees underpinning the facility." No additional financial resources are being provided. They're simply spreading existing resources more thinly.

With respect to the new insurance aspect of the EFSF, leaders state, "Purchasing this risk insurance would be offered to private investors as an option when buying bonds in the primary market." This raises a host of questions. How much do they intend to charge for the insurance? How will this price be determined.? More important, why should investors expect that the EU will perform on these insurance agreements? After all, who is taking first losses in the case of Greece?

The EU hopes to cajole "private and public financial institutions and investors" to enlarge the resources of the EFSF by co-investing in special purpose vehicles. How would these vehicles be structured, and what sweeteners, if any, would be provided to entice investors to participate?

Along these lines, EFSF head, Klaus Regling, is traveling to Beijing later this week to entice additional investment, and reports suggest Sarkozy is planning to call Hu Jintao today in hopes of eliciting support. But when thinking of Chinese involvement, it's useful to note comments made by Gao Xiching, President of the China Investment Corporation at an IMF meeting on 24-Sep-11. "A lot of people blame the Chinese for saving too much money and not spending so that made it possible for the European friends and the American friends to borrow. Yeah -- that's true. So we are going to spend more. But when we spend more, we're going to pull money out of your system." These sorts of comments do little to raise hopes for significant Chinese involvement.

The EU summit statement also indicates,  "Legislative work on the Commission proposals for a Common Consolidated Corporate Tax Base and for a Financial Transaction Tax is ongoing." The issue of corporate tax is no less contentious now than it has been for the past few years, with Ireland expressing particular objections. And while the financial transactions tax may be less contentious, at least within Europe, it would be harmful to European banks and more generally to the European economy, which needs the financial system to function more efficiently rather than less efficiently.

The EU and the European Banking Authority (EBA) state the need for guarantees on bank liabilities to support the term funding of banks and, in particular, to prevent banks from deleveraging as existing term funding arrangements mature. But banks are having difficulties because of the risks of sovereign insolvency. Are we to believe that sovereign guarantees of bank liabilities are going to improve the creditworthiness of banks at this point? And of course we're told this is an issue that the Commission "should urgently explore," with no further information available.

Banks will be required to have tier 1 capital ratios of 9%, but we're told that any plan for achieving this "must ensure that banks’ plans to strengthen capital do not lead to excessive deleveraging." How are regulators going to prevent deleveraging, short of nationalization? (Speaking of nationalization, reports suggest Greece will need to nationalize a number of its banks as a result of these measures.) 

The EBA refers to the expectation that banks will withhold dividend and bonus payments, to reach these capital targets. Will every problem in Europe be met with a call to withhold bank bonuses? Is there a view that banks can reach 9% capital ratios by lowering employee compensation? In what other industry would this constitute a reasonable microeconomic analysis?

The bottom line is that the EFSF is not getting more resources, and it's existing resources will be spread more thinly, via two vague approaches involving an insurance scheme and/or special purpose vehicles. Bank shareholders are being raided while the EU demands that banks raise additional capital. And banks are expected to respond without deleveraging.

I believe the measures announced overnight in the EU summit statement do very little to help the situation and quite possibly will serve to exacerbate the crisis. The reaction in financial markets appears to be considerably more favorable, but my sense is that this response is likely to follow the previous pattern, with initial relief and optimism giving way to concern  and skepticism as the details of the announcements are analyzed in coming days and weeks.