The European Central Bank (ECB) has finally decided to go for quantitative easing (QE). For QE to have the best chance of succeeding in the Eurozone, the ECB needed to act big, and it has delivered on that front.
“For Quantitative Easing to have the best chance of succeeding in the Eurozone, the ECB needed to act big, and it has delivered on that front,” IHS Global Insight Chief UK and European Economist Howard Archer’s analysis of European Central Bank’s policy move to undertake Quantitative Easing to curb deflation and spur the Eurozone economy follows.
From March, the ECB will buy 60 billion euro of private and public sector debt with the program intended to last through to September 2016. This works out at 1.1 trillion euro of purchases. Also significantly, the ECB has indicated that the program can be extended if necessary as it critically also says that the purchases will “in any case be conducted until we see a sustained adjustment in the path of inflation which is consistent with our aim of achieving inflation rates below, but close to 2%, over the medium term.” The 60 billion euro monthly purchases do include purchases of Asset Backed Securities and covered bonds that the ECB is already borrowing, while from March, the “Eurosystem will start to purchase euro-denominated investment-grade securities issued by euro area governments and agencies and European institutions in the secondary market.”
The initial reactions from the markets have certainly been favourable with the euro falling to new lows, bond yields falling and European stock markets rising. In addition, market inflation expectations have edged up.
QE is not a silver bullet for the Eurozone’s many problems – but it should provide some limited help to growth by adding to the stimulus that is already coming from very low oil prices and the markedly weaker euro.
However, these stimuli can only go so far in helping the Eurozone to grow and what remains crucial to long-term growth prospects will be reform aimed at boosting countries’ competitiveness and productivity.
The ECB will not hold more than 33% of any issuer’s debt and will not buy more than 25% of any issue.
Purchases will be based on the ECB’s capital key (countries’ shareholding in the ECB which effectively are in line with their GDP weighting in the Eurozone) and will have a maturity between 2 and 30 years.
The ECB will coordinate the purchases of assets “thereby safeguarding the singleness of the Eurosytem’s monetary policy” but it will make use of decentralized implementation to mobilize its resources.
As expected and obviously to try to appease Germany, much of the risk (effectively 80%) of the debt purchases will be borne by national central banks. The remaining 20% will be subject to a regime of risk sharing.
Interestingly, Draghi seemed to play down the question of the degree of “risk sharing” involved in this QE program (he called this discussion “futile”).
He emphasized that – in contrast to QE – the OMT program required full risk-sharing to achieve the purpose of supporting a particular country. With QE, Draghi seemed to suggest it does not matter at all for the intended monetary policy objective that 80% of the additional asset purchases now planned under QE will happen separately in each country by the respective national central bank.
Greek debt can be bought as long as certain criteria are met that apply to all countries. Specifically, junk-rated bonds issued by countries that are in an international assistance scheme can be bought indicating Greece needs to stick to its bail-out deal whatever the outcome of Sunday’s general election). However, Greek debt cannot effectively be bought by the ECB ahead of July 2015 when other bonds will be redeemed (given certain limitations under the current troika rules Greece is operating under).
Significantly, ECB President Mario Draghi indicated that there was unanimity among the ECB’s Governing Council that the asset-purchase program “is a true monetary policy tool in the legal sense”.
Draghi also indicated that there was “a large majority” in favour of launching QE now.
Finally, there was “consensus” on setting risk sharing at 20% and non-risk sharing at 80%.
QE is not a silver bullet for the Eurozone’s many problems – but it should provide some limited help to growth by adding to the stimulus that is already coming from very low oil prices and the markedly weaker euro. The ECB will also be hoping that QE will help Eurozone growth prospects by lifting consumer and business confidence and also by raising inflation expectations thereby reducing any temptation for consumers to hold off from making purchases in anticipation of sustained deflation.
However, these stimuli can only go so far in helping the Eurozone to grow and what remains crucial to long-term growth prospects will be reform aimed at boosting countries’ competitiveness and productivity.
There is concern that any help to Eurozone growth coming from QE in tandem with very low oil prices and the weaker euro could dilute government’s commitment to structural reform. The hope has to be that if near-term growth prospects are lifted by QE, very low oil prices and the weaker euro, this will provide a more benign backdrop that will actually facilitate structural reform.
Perhaps the best boost to near-term Eurozone growth prospects that QE will provide is if it puts more downward pressure on the euro. The euro had already fallen to an 11-year low of US$1.14595 against the dollar in anticipation of QE and it has since dipped to a new low. Further falls would further help Eurozone export prospects as well as having an upward impact on import prices.
With bond yields already so low across the Eurozone, it is questionable how effective QE will be in pushing them even lower – especially if QE does actually succeed in pushing up markets’ inflation expectations for the Eurozone.
Nevertheless, QE by the ECB may well encourage investors to move into other Eurozone assets and also encourage banks to lend more to the private sector. On a mildly encouraging note, the ECB’s January quarterly survey on Eurozone lending did point to some easing in bank’s credit standards and some pick-up in demand for loans by firms as well as for house purchases.
The European Central Bank has been a long time coming to the Quantitative Easing party but it has finally got there despite German opposition. The bar for QE has clearly always been higher for the ECB than for other central banks, notably including the US Federal Reserve, the Bank of England and the Bank of Japan. In a large part, this reflects the strength of German opposition to the ECB buying sovereign debt, including questioning whether it is legal for the ECB to undertake QE. German opposition to QE has reflected concerns that QE could dilute pressure for much-needed structural reform in many countries and those German taxpayers will end up paying for any losses made on QE. There has also clearly been appreciable concern within the ECB’s governing council over exposing the ECB to risk.
The case for QE in the Eurozone has become ever more compelling as inflation has continued to fall, inflation expectations have headed south, growth has remained anemic and credit conditions have continued to be tight. This is despite the ECB’s various stimulative actions enacted in June and September 2014, including taking its deposit interest rate into negative territory (-0.20%) and a number of measures aimed at boosting liquidity in the Eurozone (Targeted Long Term Refinancing Operations, and the buying of Asset Backed Securities and covered bonds).
The final push towards the ECB finally pulling the QE trigger undoubtedly came from the Eurozone suffering deflation of 0.2% in December. In fact, 12 of the 19 Eurozone member countries suffered deflation in December (including Lithuania which joined in January). While the ECB would normally look through any drops in the headline Eurozone inflation rate resulting from sharply falling oil prices, the bank will have been seriously concerned that the move into deflation in December will lead to a further significant weakening in inflation expectations that then feeds through to result in renewed drops in already worryingly low core inflation.