Rates in European Countries are already at record lows, which could dampen the effects of ECB quantitative easing.
After the European Central Bank (ECB) spent years of waffling over whether to pursue aggressive monetary policy to counteract deflation and stagnation in Europe, action may be just around the corner. ECB President Mario Draghi’s speech at the Federal Reserve’s annual meeting of central bankers two weeks ago gave the indication that the ECB may soon begin a large-scale asset purchasing program, also known as quantitative easing (QE). But after waiting so long to begin QE – in large part due to German aversion towards the idea – the effect will likely be smaller than expected, and indeed that it would have been two years ago.
The German factor
The Euro crisis was effectively ended when Draghi gave his ‘Whatever It Takes’ speech. Afterwards, the ECB notably did not begin a round of QE, which the US, UK, and Japan had thought necessary in the same situation.
The reason lies in Germany’s longstanding aversion to inflation, which would be expected to rise under QE, and its role as most powerful Eurozone economy. It may be a stretch to call it a fear inherited from Weimar hyperinflation, but it certainly stems from German reunification and dependence on relatively low wages for export goods. Inflation and, in turn, rising wages would put a dent in German competitiveness and could shrink a point of national pride: their huge trade surplus.
The Eurozone’s separation of fiscal and monetary authorities also creates headwinds for QE. While individual countries manage their budgets and issue bonds, all monetary policy is centralized with the ECB, who must act on behalf of Portugal, Germany, and the other 16 countries in between. The gap in monetary needs between the PIIGS countries (Portugal, Italy, Ireland, Greece, Spain) and Germany means monetary policy can almost never be spot on for all countries. The ECB will face resistance for nearly any bold action it takes. That is, until even the strong German economy slows.
For most of the first half of the year, prospects for the Eurozone economy were relatively positive. The currency crisis was over and economic surveys were optimistic. When Europe’s PMI Manufacturing Indices were universally negative in August, that optimism was wiped out. Together with France’s economy joining the malaise of the PIIGS countries, the stage finally seems to be set for QE.
Rates So Low, QE May Not Matter
Even before Draghi’s speech on August 22, yields on two-year German bonds were negative. Investors were paying the Bundesbank for the privilege of holding German debt. Longer-term yields also were at record or near-record lows across much of Europe, including Spain, Portugal, France, and Austria. Part of the reason may be a belief that the ECB implicitly guarantees individual country’s debts, but the more recent flight to safety from political crises in Eastern Europe also contributes. Draghi’s speech has pushed yields down further, not just in Germany, but also Belgium and France.
The fact that rates were already so low before markets were teased with the potential for QE may put a low ceiling on the program’s effectiveness, since there is nearly no room for long-term rates to drop further. To see why, it is crucial to understand the mechanics of how QE stimulates the economy.
There are three main reasons why QE works: portfolio rebalancing, changing inflation expectations, and signaling of the economic situation. The largest contributor to the effectiveness of QE in the US and UK has been the portfolio rebalancing effect, according to studies by Gagnon et al (2011) and Joyce et al (2011). The portfolio rebalancing effect arises when central bank purchases of long-term bonds lower yields, causing investors to reallocate their portfolios towards riskier assets like equities. As stock prices rise, the value of investors’ portfolios increases, and if they sell them, their wealth increases, providing stimulus to the economy.
It cannot be expected that European bonds yields drop much lower than their current record lows upon the announcement of QE. If it is indeed announced by Draghi, QE will be forced to work through secondary channels, most likely future inflation expectations spurring consumer and business spending. While QE will still be effective, it will not be as effective as if rates had not already been so low.
The results could be even smaller if any QE program is diluted by the politics surrounding it. Both the US and UK programs were massive – the Federal Reserve purchased $85 billion of assets for two years during its third round of QE. If the ECB’s version of QE is too small to be effective, which may be the case if it needs to compromise with German politicians, or does not last long enough for see results, QE could be ineffective. Pushing QE to be large enough and long enough will truly take a Super Mario.