The ECB finally launched a larger-than-expected QE programme last week, despite German opposition and Greek elections. President Mario Draghi hopes that it will revive the eurozone and rebut deflation. Several question are still left unanswered, however.
Few surprises come from the European Central Bank (ECB). That is, until last week when it announced it would begin a quantitative easing (QE) program to purchase €60 billion a month.
The program itself was not surprising since, in typical ECB fashion, it had been alluded to for months and rumors were rampant in the lead-up to ECB President Mario Draghi’s Thursday statement.
Instead, the surprise was the size. The ECB and national central banks will purchase €10-€20 billion more assets each month than expected, €60 billion in total. Markets jumped at the news, but a closer look at the program and the Eurozone reveals that this program is very different than QE in the UK and US, raising these and many other questions.
How much inflation will the ECB allow before ending QE?
In his announcement, Mr. Draghi said that QE would continue “until we see a sustained adjustment in the path of inflation.” With Eurozone inflation dropping below zero in December, and a handful of European countries experiencing deflation for most of 2014, the required adjustment is significant. Of course, the ECB faces two challenges in reflating prices.
The first is the Bundesbank’s Jens Weidmann, who believes QE is a reckless gamble that will lead to high inflation and excessive sovereign debt.
Second, the ECB’s price stability mission is a bit different than that of the Federal Reserve and Bank of England. Instead of aiming to be near the 2% inflation target, either above or below, the ECB is required to keep inflation near – but not above – the 2% target. The ECB is much more sensitive to overshooting its target than its Anglophone peers, and is likely to end QE far before Eurozone inflation reaches 2%.
Will the Greek, Irish, Spanish, and Portuguese central banks participate?
The ECB edition of QE will also look different than its British and American counterparts. Only 20% of the asset purchases will be made directly by the ECB, with the rest being carried out by the national banks of Eurozone countries. This will reduce the amount of risk from holding sovereign debt that will be shared between, for example, Greece and Germany. It was probably a necessary compromise to get the less-indebted Northern European countries to sign off.
The catch is that the ECB may not allow the countries that received EU and IMF bailouts during the Euro crisis to participate fully. In the announcement, Mr. Draghi said that ‘additional eligibility criteria’ may apply to these countries, which includes Greece, Ireland, Spain, and Portugal.
It remains unclear what those criteria are. If they make it significantly harder for those countries to participate, then the ECB will be cutting out the countries that need QE the most and the program is more likely to be a failed policy.
How much will Germany cooperate?
Mr. Weidmann, in his role as voting member of the ECB Board of Governors and most senior monetary policy official in Germany, has aggressively opposed QE. Nevertheless, the majority of the assets purchased under QE will be done so by the Eurozone’s national central banks.
Germany’s Bundesbank is responsible for approximately €14 billion per month. It is unclear in the statement how compulsory these purchases are, and whether or not the ECB can compel the Bundesbank to make them.
The Germans could also choose the assets its purchases strategically to lessen the impact of the program, which would likely start by categorically refusing to buy assets from the bailout countries.
Will it change fiscal policy?
Germany’s usual concern over QE has been the prospect of inflation, but in an interview over the weekend Mr. Weidmann raised a new one: Eurozone countries will draft wildly undisciplined budgets, knowing that their central banks will keep interest rates low by purchasing the new debt.
At face value, however, the proposition seems to be based less in reality and more in German disdain for supposedly irresponsible governments in countries like Greece and Italy.
On top of that, interest rates on Southern European bonds were already extremely low before QE was officially announced last week. Spanish 10 year bonds are trading significantly lower than US 10 year bonds. The prospect of this kind of machination between central banks and governments seems unlikely, especially since any additional eligibility criteria for bailout countries will limit their QE options.
Will it work?
The jury is out on this question. QE is thought to work through four different channels. The most important is the portfolio rebalancing effect: by purchasing assets, interest rates fall and investors move their money into better yielding, riskier assets. Since rates in Europe are already so low, this effect could be muted in comparison to what it was in the US and UK.
The other three are changing inflation expectations, signaling, and weakening the Euro. Changing inflation expectations will raise the cost of hoarding cash and hopefully spur more consumer spending and bank lending.
The most talked about channel since Mr. Draghi’s announcement has been weakening the Euro. The thought process is this: lower rates lead to a weaker currency. A weaker currency makes exports appear cheaper to potential buyers outside the Eurozone, giving a boost to European economies.
This could potentially be a source of strength for Europe, but there is some uncertainty over that. Looking at some correlations, it seems the relationship between exports and currency might be backwards for Europe. Even if conventional wisdom holds for the Eurozone, the recent rate cuts by Switzerland and Denmark (two major trading partners of the Eurozone) will have damped the currency channel.
Maybe QE would have been more effective if it was started years ago, like in the US and UK, but even at this late date it is crucial that the ECB was willing to step in and try to revive Europe’s stagnate economy.
