The Basics of “Outright Monetary Transactions” and Sterilized Bond Purchases

Yesterday after much hoopla, press and leaks (and I thought the CIA couldn’t keep their secrets) the ECB and Super Mario, introduced their new “Outright Monetary Transaction” bond purchase sterilization program. Does that confuse you, it sure confuses me, and so I decided to take a look at this plan step by step.

A) What will the European Central Bank buy?

The ECB will buy sovereign bonds with maturities dates of up to 3 years with the aim of “protecting an appropriate monetary policy transmission and the singleness of the monetary policy.”

B) Whose bonds will the ECB buy and under what conditions?

The ECB will only buy the bonds of countries that have applied to the EFSF/ESM and accepted a concurrent “macroeconomic adjustment programme or a precautionary programme.” ‘Precautionary programme’ refers to a species of program buried deep in the EFSF’s repertoire of credit facilities whereby a country can apply to the EFSF to arrange a backstop. The stronger the macro economy of the applicant, the fewer the conditions attached to the program.

In order to qualify for these purchases, a country must submit to an austerity program that would be monitored by other European nations and, potentially, the International Monetary Fund. Under the plan, a country would apply to the European Financial Stability Fund for assistance. To be approved, it must come up with an agreed upon plan to lower its deficit and its debts and usually its spending. Once conditions are in place, Draghi said, the ECB can step in to purchase bonds, helping lower rates.

C) Will bonds purchased under OMT be super senior to other bonds by virtue of being owned by the ECB?

No 

D) Is there a limit to the purchases?

No.

E) Will the purchases be sterilized?

Here the ECB was quite specific: “The liquidity created through Outright Monetary Transactions will be fully sterilized.” (see explanation below)

F) What are sterilized bond purchases?

A form of monetary action in which a central bank or federal reserve attempts to insulate itself from the foreign exchange market to counteract the effects of a changing monetary base. The sterilization process is used to manipulate the value of one domestic currency relative to another, and is initiated in the forex market.

Wikipedia explains sterilized intervention as:

Sterilization in macroeconomics refers to the actions taken by a country’s central bank to counter the effects on the money supply caused by a balance of payments surplus or deficit.^[1] This can involve open market operations undertaken by the central bank whose aim is to neutralize the impact of associated foreign exchange operations.^[2] The opposite is unsterilized intervention, where monetary authorities have not insulated their country’s domestic money supply and internal balance against foreign exchange intervention.

Sterilization is most often used in the context of a central bank that takes actions to negate potentially harmful impacts of capital inflows – such as currency and inflation – both of which can reduce export competitiveness. More generally, it may refer to any form of monetary policy which seeks to hold the domestic money supply unchanged despite in the face of external shocks or other changes, including the flow of capital out of the relevant area (generally, a country).

While markets are perhaps viewing this as the ECB trying to solve the European sovereign debt crisis through the purchase of distressed bonds, instead it reads to us as though the ECB is trying to compel states to accept the structural adjustments that they need. As Draghi said during the press conference, “No central bank intervention is effective without concurrent (fiscal) policy action.” Insofar as the program accomplishes the goal of compelling fiscal policy action, it’s constructive.

It sounds simple, except it is fraught with potential pitfalls.

For one, the ECB is specifically prohibited from financing the debts of member governments. To get around this, Draghi has argued that the ECB has a mandate to conduct a single monetary policy in the 17-member Euro area.