Sterilization and ECB quantitative easing

Draghi's ECB initiative of bond buying through "Outright Monetary Transactions" was accompanied by a statement that purchases would be entirely sterilized. I think this implies limitations on the capacity of the program, although I haven't thought it through carefully yet.

Markets were up substantially on this news, which I had heard predicted already over the summer by Wall St. types.

WSJ: ... Sterilization helps the ECB distinguish its plan from the quantitative easing programs of the Federal Reserve and the Bank of England, which are explicitly aimed at supporting the money supply. However, the “Outright Monetary Transactions” still resemble “QE” programs in as much as both tend to depress bond yields, lowering the most important reference interest rates for the economy.

It’s a fine point, but one that the ECB hoped would persuade the arch-monetarist thinkers at the Deutsche Bundesbank that it was still acting within its mandate. They were wrong. Within two hours, the Deutsche Bundesbank issued a statement reaffirming that its President Jens Weidmann, the only person to disagree with the plan, still considers bond purchases “too close to financing states via the printing press.”

In principle, “sterilization” is a process that ensures that individual actions by the central bank don’t result in an overall increase in the money supply. Monetarist theory dictates, after all, that it is excessive monetary growth that leads to inflation, which is what the ECB is exclusively mandated to guard against. ... As of today, the precautionary hoarding of reserves by euro-zone banks is so great that banks are holding over €770 billion in excess reserves in accounts at the ECB, voluntarily “sterilizing” money the ECB created without forcing it to lift a finger.

... The ECB is sterilizing another €209 billion by paying only 0.01% on the deposits it auctions. In the current environment, it does not seem like the ECB would struggle to withdraw from the market any amount of liquidity it wanted to. Even so, the numbers implicit in the ECB’s new bond-buying scheme are daunting. Excluding treasury bills, there are some €390 billion in Italian bonds that fall due in the next three years.

For Spain, the number is €203 billion, for Portugal and Ireland combined, another €50 billion, according to national debt agency data. In all, a total of over €640 billion. Of this, it seems likely that the ECB already holds — and sterilizes — a large part of its €209 billion SMP portfolio. There are no precise data yet on the ECB’s holdings, but only around 40 billion euros is accounted for by Greece.

Thus the amount that the ECB needs to sterilize could easily double or treble from its current level. This may incline it to sterilize more over a longer time-frame of a month or three months or even more, so as to reduce the potential for volatility in the money market. The ECB has already examined such options internally two years ago, but chose not to proceed.