Praet explores QE transmission channels

The European Central Bank (ECB) could achieve greater portfolio rebalancing and signalling effects by buying sovereign rather than corporate bonds, according to chief economist Peter Praet.

Speaking at the Peterson Institute for International Economics last night in Washington, DC, Praet discussed the different transmission channels associated with each policy.

"Purchases of different asset classes will affect private sector financing conditions to varying degrees as they will activate different transmission channels and affect different spread components," he explained.

One option for the ECB is to buy corporate bonds. Praet said that such purchases could lower funding costs for companies that are large enough to "tap credit markets directly", while creating the "scope" for banks to lend to smaller enterprises.

However, the market for corporate bonds is "relatively thin" across the eurozone, which could limit the impact of the policy. "This could imply that potential portfolio rebalancing and signalling effects would be contained," Praet said.

These effects would be much larger if the ECB bought sovereign bonds. Praet said buying government debt would "likely entail a stronger signal" that should "not only compress the risk-free curve further" but also spill over to inflation expectations.

Moreover, the ECB would expect to see "broad" portfolio effects that could see banks shifting out of sovereign bonds and lending more.

"Our analysis shows that sovereign spreads in some member states are still preventing lending rates from falling further… Although these spreads have narrowed sharply, there remain considerable differences in real – that is, inflation adjusted – yields across countries," Praet said.

"Therefore, if purchases of government bonds were to reduce banks' opportunity cost of lending by lowering the return of other alternative investments, this might create the incentives for banks to extend credit to the private sector."

For now it is unclear whether the ECB will pursue either policy. With the possibility that inflation will drop below zero in the coming months on the back of falling oil prices, it will likely come under pressure to launch further easing measures.

Following last week's policy decision, Draghi announced the governing council would reassess its stance and decide whether further action was needed "early next year". For now the ECB staff have "stepped up" their technical preparations.

"The exercise we are doing now with the staff is to see if we have to decide [on] new measures to expand the balance sheet, what the best combination is we can have," Praet said.