The ‘Maturity Crunch’
Central Bank Policy Implementation and the ECB's Plan
In order to avoid the appearance that its plan to buy bonds of peripheral governments does indeed amount to 'funding of governments by the printing press', the ECB has tied the plan to the condition that it has to happen in parallel with EFSF/ESM rescues. However, that was not all – there was another stipulation mentioned by Mario Draghi during the press conference. We briefly remarked on this already in our summary and analysis of the ECB decision last week.
The other part of the plan, which is supposed to make the operation more akin to a 'monetary policy' type intervention, is to concentrate the buying on the short end of the yield curve. The thinking behind this is that in 'normal times', the central bank is mainly aiming to manipulate overnight rates in the interbank funding markets as well as other very short dated interest rates rates. Hence intervention in the short end of the curve closely resembles this 'normal' implementation of monetary policy. With this, the ECB probably also tries to differentiate its actions from those of the Fed and BoE.
Usually, the central bank determines a 'target rate' for overnight funds, and whenever credit demand wanes and interbank rates drift below this target, it is supposed drain liquidity. Whenever credit demand threatens to push interbank rates above the target rate, it will add liquidity.
During boom times, very little 'draining' tends to happen. As a rule, central bank target rates will be too low, and as speculative demand for short term credit keeps increasing during a boom, its liquidity injections – which provide banks with the reserves required to keep the credit expansion going – will aid and abet the growth in credit and money supply initiated by the commercial banks.
In the euro area, this method of overnight rate targeting has produced roughly a 130% expansion of the true money supply in the first decade of the euro's existence – about twice the money supply expansion that occurred in the US during the 'roaring twenties' (Murray Rothbard notes in 'America's Great Depression' that the US true money supply expanded by about 65% in the allegedly 'non-inflationary' boom of the 1920's).
This expansion of money and credit is the root cause of the financial and economic crisis the euro area is in now. This point cannot be stressed often enough: the crisis has nothing to do with the 'different state of economic development' or the 'different work ethic' of the countries concerned. It is solely a result of the preceding credit expansion.
Since long term interest rates are essentially the sum of the expected path of short term interest rates plus a risk and price premium, the central bank's manipulation of short term rates will usually also be reflected in long term rates.
In the euro area's periphery, the central bank has lost control over interest rates since the crisis has begun. The market these days usually expresses growing doubts about the solvency of sovereign debtors by flattening their yield curve: short term rates will tend to rise faster than long term ones. This in essence indicates that default (or a bailout application) is expected to happen in the near future. It is possible that this effect has also influenced the ECB's decision to concentrate future bond buying on the short end of the yield curve. However, as is usually the case with such interventions, there are likely to be unintended consequences.
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