VoxEU: Outright Monetary Transactions sterilised?

30 October 2012

Sterilisation - where purchases of assets by a central bank are offset by withdrawals - may help the ECB to control inflation, however this column maintains the ECB's current approach may be fraught with danger. The ECB's only real hope may be that its approach makes a eurozone default impossible.

There has been some scepticism as to whether the ECB’s ‘sterilisation’ could work, given that the ECB is also offering unlimited liquidity against suitable collateral. Even if the sterilisation is successful, Outright Monetary Transactions, if not properly designed, may compromise the control that the ECB can exercise over the inflation process.

What’s different about sterilisation?

Sterilisation, the ECB claims, is an important feature that differentiates Outright Monetary Transactions from the rather unconventional easing policies undertaken by the Bank of Japan, the US Federal Reserve Bank, the Bank of England, and other central banks. Like Outright Monetary Transactions, these policies depress bond yields and lower important reference interest rates for the economy. But, unlike Outright Monetary Transactions sterilisation, other unconventional policies explicitly aim at supporting the money supply. By preventing an overall increase in the money supply, sterilisation is supposed to prevent inflation that would otherwise occur. Textbook monetarist theory dictates, after all, that it is excessive monetary growth that leads to inflation, which is what the ECB is mandated to guard against.

Outright Monetary Transactions sterilised?

There are two dimensions of Outright Monetary Transactions that may affect its ability to pin down the stochastic path of inflation.

• First, the change in the asset portfolio of the central bank. Through sterilisation, the policy amounts to an increase in longer-term asset holdings (the purchased secondary market bonds) funded by shorter-term borrowing. As such, deposit account liabilities increase as the ECB sterilises the increase in the reserves that would otherwise take place after the bond purchases. This, in effect, tilts the ECB’s asset portfolio towards a longer duration. However, given that the ECB is relatively clear that it will only purchase secondary market bonds with maturities between one and three years from countries which have applied for EFSF/ESM support, this asset change is likely to allow the ECB to continue to control the stochastic path of inflation. Sterilisation should ensure that the overall level of money supply, and hence inflation, is also contained.
• The second dimension is more subtle and relates to sovereign default risk. Authors Michael McMahon, Udara Peiris and Herakles Polemarchakis illustrate the problem as it applies to the ECB. In a world where the possibility of (sovereign) default does not exist, any (sovereign) bond of the same maturity is a perfect substitute for any other. However, an environment characterised by a wide distribution of yields implies that the default risks of different eurozone sovereign bonds are very different in both timing and likelihood. Holdings of different bonds, then, have different distributions of payoffs and, as a consequence of the ECB holding these bonds outright in large quantities, they also have different implications for the amount of money supply in the eurozone. That is, if default does occur, interest needs to be paid out on the deposit accounts, but interest is not received from the defaulted bonds. This affects the outstanding money supply. Sterilisation, if effective, can indeed ensure that Outright Monetary Transactions do not affect the total money supply ex ante. But sterilisation is incapable of achieving this ex post in a world where sovereign default is a possibility.

Conclusions

For Outright Monetary Transactions not to impact inflation expectations, the ECB must hope that the programme, together with the raft of other packages and measures designed to facilitate sovereign solvency, will rule out any possibility of default. Alternatively, the ECB can pre-commit to a target portfolio composition, as is the case in the US. For the time being, the fact remains that the ECB will purchase unrestricted quantities of sovereign bonds of varying yields supported by differing expectations about default. By doing so, it introduces a real risk that inflation expectations could become de-anchored and, importantly, this is expected to happen well before any actual default occurs.

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