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Kiel Institute analyses implications of the PSPP for euro area monetary policy

15.06.2015

The Kiel Institute has advised the European Parliament about the risks of the Public Sector Purchase Programme (PSPP) the ECB started in March 2015. “When future economic circumstances urge the ECB to considerably tighten its monetary policy stance these risks are difficult to quantify, but scenario projections indicate that they are economically significant,” Prof. Stefan Kooths, Head of the Forecasting Centre at the Kiel Institute says.

The ECB has launched the PSPP in March 2015. The programme extends existing asset purchase programmes (€10 billion per month) to debt securities with a market value of €50 billion per month. The major part (€44 billion per month) of the PSPP will be used mainly to purchase sovereign debt of euro area member states and will be allocated across countries in correspondence to the ECB’s capital key. The ECB has set several criteria and limits for bonds to be eligible for the PSPP, most prominently the limit not to hold more than 25 percent of any given issue of bonds. According to the ECB the 25 percent per issue limit was set to avoid the question of monetary financing of governments as any higher ownership share would give the Eurosystem a blocking minority in any restructuring process. However, the mechanism of monetary government financing via sovereign bond purchases by the central bank works irrespective of such a blocking position.

Via the PSPP, the ECB is taking substantial risks on its balance sheet. Major risks are sovereign default risks and interest rate risks both of which are difficult to quantify. Interest rate risks emerge as soon as future circumstances urge the ECB to tighten its monetary policy stance while still having a significant amount of low yielding bonds on its balance sheet. Scenarios for present values variations indicate substantial interest rate risks if the ECB were to start severe tightening of its monetary policy directly after the envisaged end of the PSPP. Of course, these risks diminish the later and the slower interest rates increase. The potential losses due to the PSPP should be compared to the expected interest earnings from holding additional securities. These earnings will, however, be relatively small due to the low yields of relevant bonds in the euro area. Estimates indicate that the expected interest payments received from sovereign debt will amount to about €4 billion between March 2015 and September 2016. By international comparison, the expected interest payments due to Quantitative Easing programmes received by the Eurosystem are also relatively small. For example, the Fed started its Quantitative Easing programmes in a period when yields of US government bonds were considerably higher. Therefore, the Fed’s interest earnings were higher and its interest rate risk exposure lower compared to the ECB. Overall, the financial risks resulting from its Quantitative Easing programme seem to be higher for the ECB than for the Fed.

The PSPP could have several implications for monetary policy. First, it increases the incentives for the ECB to choose inferior more accommodating monetary policy stance than its mandate by itself would dictate to avoid losses due to interest rate risks or due to sovereign debt defaults. Second, it weakens the independence of the ECB by making her more dependent on the fiscal soundness of the euro area member states. Third, the financial risks that are related to the PSPP may be perceived by market participants as a signal that interest rates will remain low for an even longer period than they would otherwise be. However, this implication may be intended by the ECB as this perception could help to lower long-run interest rates. Fourth, in extreme scenarios the PSPP significantly harms the financial health of the Eurosystem reducing its capacity to ensure price stability. Fifth, the PSPP may contribute to higher volatilities in the targeted bond markets or feed asset price bubbles. This would counteract some of the envisaged effects. However, such risks are difficult to assess. Sixth, if the ECB wants to expand its asset purchase programmes it may have to deviate from its current limits and criteria for eligible debt securities.

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