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Euro zone monetary policy outlook

August 2019

Why yield curve control should be Draghi’s parting shot

The euro zone should adopt a radical Japanese style monetary policy if it wants to avoid Japanification.

A Japanese rabbit for Mario Draghi?

The European Central Bank chief should be paying particularly close attention to his Japanese fellow central bankers.

That’s because the eurozone, with its multi-speed economy, needs a radical, Japan-style “yield curve control” policy (YCC) almost as much as Japan does. It should be the last rabbit he pulls from his hat before stepping down later this year.

Japan has been the global vanguard for unorthodox monetary policymaking. Its experiments with helicopter money in the 1930s and, more recently, with quantitative easing and negative interest rates, have offered other central banks valuable lessons.

Thanks to its YCC policy, the Bank of Japan is once again in its counterparts’ sights as monetary authorities search for ways to reduce stimulus without endangering growth.

To understand why, it’s important to look how and why the policy works.

Under YCC, the BOJ undertakes bond purchases with specific aims of maintaining short-term rates at minus 0.1 per cent and 10-year government bond yields at zero per cent.

This policy’s chief attraction is that it has served as a “stealth” tapering of QE. The BOJ has managed to reduce its annual bond purchases by JPY60 trillion to 20 trillion without disrupting financial markets.

It has thus been able to avoid a repeat of the US taper tantrum in 2013, when bond yields surged after the Federal Reserve announced plans to retrench from QE.

YCC’s other great success has been in helping Japan start to grow out of debt by keeping its borrowing costs below the level of its nominal economic growth, a key element of what Bridgewater’s Ray Dalio calls a “beautiful deleveraging”.

From this perspective, YCC is beneficial to the eurozone, or at least some parts of it. This is especially true for Italy, whose public debt burden of 130 per cent of GDP, the region’s second highest after Greece, is far from sustainable.

The country’s interest payments amount to 4 per cent of GDP, four times those of Germany and double the OECD average. Moreover, its debt servicing costs are 0.9 percentage points above its nominal GDP growth rate (see chart).

not so beautiful

Italy's nominal GDP rate vs 10-year bond yield

Italy YCC

*Borrowing costs below the level of its nominal economic growth. Source: Refinitiv, data covering period 31.12.1999 - 31.07.2019

In another parallel with Japan, the eurozone periphery is struggling to boost private lending. Without the ECB operating the printing press, the economic recovery in southern Europe, where credit is still contracting, could soon fizzle out.

For a region where some countries require monetary tightening and others stimulus, a US-style exit from ultra-loose policy could prove damaging.

A European YCC, by contrast, would provide targeted support to the continent’s south.

In practice, the ECB could introduce a cap of, say, 0.5 per cent for eurozone 10-year debt. While it represents a sharp adjustment, it should help close the gap between Italy’s benchmark borrowing costs and its nominal GDP rate, which will help the country reduce debt relative to the size of its economy.

YCC could also ease the strain on eurozone banks, which not only own large amounts of government bonds but are also struggling to shed nearly EUR800 billion of non-performing debt.

The policy would, for instance, lift the pressure on Italian banks, which collectively hold 28 per cent of domestic sovereign debt and struggle with a pile of soured loans.

All this is not to say YCC would be an easy sell. Because the cost of debt would be suppressed, governments may be tempted to borrow more. To prevent potentially reckless borrowing and assuage the concerns of fiscal hawks such as Germany, the ECB could make the yield cap conditional on predefined fiscal discipline targets.

In theory, YCC commits a central bank to buying a potentially unlimited amount of debt. But in practice, as Japan shows, the ECB’s overall bond purchases should gradually fall without an explicit tapering programme.

The ECB would have to be prepared to defend its yield targets as vigorously as the BOJ, which has carried out “infinite bond tenders” only a handful of times since the inception of the scheme to keep rates from rising during bond market sell-offs.

That shouldn’t pose too much of a problem, though. The ECB has proved both flexible and credible, benefiting from a rigorous institutional framework that guards its political independence.

YCC could prove a practical solution to the conundrum facing Draghi. It could — and indeed should — be his parting shot.