The European Central Bank (ECB) announced an expanded quantitative easing (QE) programme on 22 January. Starting in March 2015, the ECB will buy, on a monthly basis, EUR60bn worth of Euro Area sovereign bonds and private sector securities. The purchases will continue until September 2016, although the programme could also become open ended until a “sustained adjustment in the path of inflation” is observed. In making large-scale purchases of sovereign bonds, the ECB has (belatedly) joined the three other major central banks (the Japanese, UK and US central banks), which had resorted to QE after they ran out of room to reduce interest rates any further.
If monetary policy were to be reduced to one job, it would be to ensure that temporary shocks to inflation do not become permanent. A central bank can do nothing to stop US oil producers from flooding the market and driving down international oil prices. However, it can prevent lower oil prices from turning into a deflationary spiral. The key to doing so is to ensure the stability of inflation expectations. If people expect inflation will soon revert to a certain rate (say “below, but close to 2%”), they will ignore the fall in oil prices when they set prices for other goods and wages. This will ensure that the oil price shock will soon fade away. If, on the other hand, they believe the central bank is unwilling or unable to bring inflation back under control, then the oil price shock can feed into lower prices for other goods and wages, and the shock could ultimately turn into a permanent deflation (see our commentary dated January 25).
There has been evidence that the recent sharp fall in oil prices has unhinged inflation expectations in the Euro Area. Market-based measures of inflation expectations have fallen sharply since the second half of 2014. This indicates that market participants believed that the effect of lower oil prices would become permanent as the ECB was either unwilling or powerless to react. The latest move by the ECB seems to have partially reversed this trend for now.
How can the latest move by the ECB prevent a prolonged period of deflation? Three channels are important in addressing this question. First, QE provides a signal that the ECB is taking its inflation target seriously and is willing to do whatever it takes to meet it. The recovery in inflation expectations following the QE announcement suggests that the ECB may have had some success in restoring market confidence. Second, by lowering the yields on government bonds, the ECB may induce banks to lend more to corporations and households, thus boosting aggregate demand and inflation. Finally, by weakening the euro against other currencies, the ECB’s monetary expansion would increase the price of imported goods and services. Of all these channels, the last one is likely to have the biggest impact on inflation. Since the ECB announcement, the euro has depreciated 3.0% against the US dollar.
However, there are risks to the ECB strategy. First, bond yields in the Euro Area are already very low. Any QE boost is therefore likely to be limited as it would result in only a few basis points movement in bond yields. Second, European banks are less likely to respond to QE than US banks did as European corporates are highly leveraged and therefore unlikely to gain from lower interest rates. Third, by mutualising the risk of default across the Euro Area, the ECB is venturing into the realm of fiscal policy, which could result in cross-border transfers from northern Europe to the troubled periphery countries. This may also reduce the incentives of periphery countries to undertake the necessary reforms to increase growth and reduce their debt burden.
Moreover, the recent historical experience shows that QE can have large cross-border spillover effects. These effects had already started ahead of the ECB’s decision with the Swiss National Bank abandoning its exchange rate floor and the Danish central bank pushing interest rates further into negative territory in order to maintain its currency peg to the euro. Emerging markets (EMs) may see some additional capital inflows from the Euro Area searching for higher yields. However, what is different this time around is the market expectations of a possible increase in US interest rates later this year. Most likely, the largest Euro Area capital flows will therefore be to the US, with a continued strengthening of the US dollar against all other major currencies.
In the end, monetary policy can be powerful in the short-term but is unlikely to change the long-term predicament of the Euro Area. The ECB may succeed in preventing prolonged deflation from taking hold, but this is a not a sufficient condition for sustainable growth. As Mario Draghi, President of the ECB, has emphasised on multiple occasions, structural reforms in the labour and product markets in the Euro Area are essential for a sustained recovery in the currency area. The ECB might love QE for now, but it is up to the governments to implement the required structural reforms.
