European Central Bank QE: A little late to the party

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The ECB meets on 22 January and with Eurozone inflation having turned negative and growth stalling, there is a high probability it will announce a fully-fledged bond buying program. Its immediate goal will be to cap peripheral bond yields and systemic risk ahead of Greek elections on 25 January. Ultimately it will be tasked with staving off deflation and generating jobs – a tall ask for a measure of last resort which by definition has its limitations. Its effectiveness will depend on its size – likely to be around €1 trn – and modalities but will be curtailed by its late timing. For EUR/USD it likely means further downside in coming months, in my view.

 

ECB QE: a measure of last-resort with some ambitious objectives

The European Central Bank (ECB) holds its first policy meeting of the year on 22 January, with markets holding their breath as to whether the ECB finally announces the start of a sovereign bond purchasing program. Once markets digest the modalities of such a program, including its size, the bigger questions are will it work and how. Few topics have divided economists, policy-makers and markets as much as the effectiveness of quantitative easing and the ECB’s program is unlikely to be any different.

Before going further, it’s worth bearing in mind that QE is in most instances a measure of last resort. When ultra-low policy rates have failed to depress yields and/or spur lending and growth, exchange rate policy has run its course and fiscal stimulus is not possible, advisable or simply not working, QE is introduced to do the heavy-lifting. So by definition QE may well have some undesired side-effects.  If it was all upside, QE would be the first policy that central banks turn to, not the last. It would thus be inappropriate to lay the blame for irrational risk-taking, distortions in asset prices (including bonds, equities and housing) and the risk of inflationary pressure solely at the feet of QE and central bankers.

That caveat aside, whether a fully-fledged QE will work depends on what we think the ECB’s objective is. I would argue that the immediate goal is to cap yields of the weaker member states’ sovereign bonds – a success or failure which can be measured pretty accurately and quickly. Bar Greece, peripheral sovereign yields are low by historical standards, with 10-year yields at 1.3% in Ireland, 1.6% in Spain and 2.6% in Portugal (see Figures 1 & 2).

olivier desbarres fig1

Figure 1: Greek government bond yields have risen above 10%…

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Figure 2: …but other sovereign yields have been far better behaved

 

 

 

 

 

 

 

 

 

 

 

So ultimately such a program will need to be judged on whether it succeeds in the broader objectives of circumventing deflation in the Eurozone – the icing on the cake – and ultimately boosting morose economic and employment growth – the cherry on the icing. Such a verdict will take longer to deliver.

  • Eurozone real GDP growth only recovered very slowly last year and the Eurozone’s real GDP has effectively flat-lined since end-2011 (see Figure 3);
  • The unemployment rate has been stuck at 11.5% since May 2014 – nearly twice the rate of the US and the UK (see Figure 4);
  • CPI-inflation turned negative (-0.2% yoy in December) for the first time in five years, raising serious doubts about the ECB’s 2% inflation mandate (see Figure 4).
fig3

Figure 3: Eurozone GDP growth is failing to take off…

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Figure 4: …with unemployment and inflation painting a similarly bearish picture

 

 

 

 

 

 

 

 

 

 

 

QE has its limitations

A bold QE program may have a positive impact on growth via a number of channels but they each have their limitations:

  • Lower yields and government’s financing costs, giving a little more room for fiscal stimulus. However, bar Germany, major Eurozone member states such still have large fiscal deficits (e.g. France, 4.3% of GDP) or debt (e.g. Italy 136% of GDP) limiting the scope for such stimulus.  Germany, which is running a small 0.2% of GDP fiscal surplus and has modest debt of 75% GDP, arguably has the room but not the appetite for fiscal expansion, with Chancellor Merkel’s government likely to continue favouring growth via strong exports.

 

  • Free up banks’ balance sheets, thus increasing the scope for lending and in turn consumer spending and corporate investment. However, as the experience of Japan has shown, the price and quantity of available capital is only one half of the equation. Households and corporates’ appetite to borrow is the other half and is likely to be constrained by an uncertain economic outlook.

 

  • Reduce systemic risk and increase market confidence thereby driving equities higher. However, the spectre of the Syriza party winning the Greek elections on 25 January and renegotiating the terms and conditions of the country’s bailout package is likely to keep systemic risk bubbling and a lid on market confidence in coming weeks (see What you may have missed and why it matters).

 

  • Weaken the Euro further and improve export competitiveness. Yet a weaker Euro will help the Eurozone’s exporters to very varying degrees. Germany, an open economy which posted the world’s largest current account surplus in 2013 ($255 bn) is likely to yet again be a key beneficiary of a weaker euro – even if German exporters rightly argue that there’s more to competitiveness than a cheap currency.

 

Size matters…

The size, timing and details of a bond-buying program will be key. The ECB’s previous foray into sovereign bond-buying, the Securities Markets Programme (SMP) which terminated in September 2012, amounted to only €212 bn (2% of GDP). It is generally considered not to have been a success. This time around ECB President Draghi said he would return the central bank’s balance sheet to March 2012 levels, implying a €1 trn (9 % of GDP) bond buying program. This size would likely to have to include sovereign bonds, not just private debt. By comparison, the Bank of England’s QE has amounted to about 23% of GDP with the purchase mostly of gilts spread over 3.5 years (see Figure 5).

Figure 5: ECB bond buying to start when Fed and BoE programs have already ended

Figure 5: ECB bond buying to start when Fed and BoE programs have already ended

 

 

 

 

 

 

 

 

 

 

Ironically the ECB SMP’s successor, the Outright Monetary Transactions (OMT), has not bought a single bond in the secondary market but the promise to do so is considered to have successfully helped lower yields and elevate credit growth. So clearly the timing and modalities of the announcement matter as much if not more than the actual size of the bonds which will potentially be purchased.

 

…and so does timing

The most common metaphors for QE – often referred to as an “unconventional monetary policy” – are drugs related. But I think a more appropriate metaphor is that of a drinks party. You may not want to be first to show up and if you do make sure you’re bringing the host an impressive gift.  Similarly if you are the first to announce QE make sure its scope does not underwhelm. Like at a party, you want QE to make a bold entrance but also a dignified exit.

My main concern about the ECB’s likely bond buying program is that it’s quite late to the party. The Fed stopped its purchases of mortgage-backed securities and Treasury notes in October 2014 while the BoE’s last QE size increase was in July 2012 (see Figure 6). Bearish growth and inflation expectations for the Eurozone are well entrenched which leaves the QE having to work harder to achieve the same result, in my view. The five-year, five-year inflation swap, a closely watched indicator of medium-term inflation expectations, has fallen below 1.6%.

Therefore, almost regardless of its size, wholesale fiscal and structural reforms would have to go hand in hand with QE for it to have the desired impact on growth and employment in the Eurozone. And that’s when things break down. Appetite for reform of labour markets, tax, administrative, and services market competition is weak – France being a point in hand (See When you’re behind, play a big hand: “EU light”).

 

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Figure 6: Timeline of Bank of England QE

 

 

Olivier Desbarres currently works as an independent commentator on G10 and Emerging Markets. He is a former G10 and emerging markets economist, rates and currency strategist with over 15 years’ experience with two of the world’s largest investment banks.


Sources

Figure 1 – Bank of Greece;  Note: weekly data

Figure 2 – Marketwatch.com

Figure 3 – Eurostat

Figure 4 – Eurostat

Figure 5 – National central banks

Figure 6 – Bank of England; Note: BoE bought gilts from financial institutions, along with a smaller amount of relatively high-quality debt issued by private companies

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