The European Version of Quantitative Easing
The European Central Bank (ECB) has once again managed to catch investors by surprise, not because of the additional measures it announced this Thursday, September 4, but rather because of the timing. Most analysts expected words, not yet action. Instead, the central bank’s president Mario Draghi not only announced that the two key interest rates will be cut once again, he also further cut the deposit rate, thereby increasing the levy banks have recently started to pay for depositing money at the central bank. More importantly, while stopping short of launching a broad based U.S.-style quantitative easing (QE) program of sovereign bond purchases, Draghi announced that the ECB will start to buy private sector asset backed securities (ABS) in October. He did not yet specify the quantity of securities the central bank would purchase, in a sign that some relevant details still need to be worked out. But the latest decisions taken by the governing council are nonetheless significant, as the ECB is de facto launching QE in all but name.
As Draghi pointed out, the ECB has now reached the zero lower bound. Conventional monetary tools are exhausted—in his own words “technical adjustments are not possible any longer.” If data on inflation and economic activity get worse, broad based QE will follow, including government bond purchases. I would argue that the ECB does not want to go down that route, but it is prepared to embark on such a program if conditions dramatically deteriorate.
Broad based QE is still the weapon of last resort, just as it was the case with Outright Monetary Transactions (OMT) in 2012. It should be seen as a life insurance policy, not a readily available tool. Since in Draghi’s own words monetary policy can only do so much, the latest ECB decisions should therefore be seen as a warning and an appeal to politicians, both in the periphery as well as the core of the Euro Zone to get their act together. Without structural reforms, the ECB’s actions will not manage to lift the economy.
In Draghi’s own definition, stimulating demand through fiscal support does not mean a dramatic increase of government spending, nor does it mean that the rules of the growth and stability pact should be ignored. On the contrary, the goal should be to lower taxes while cutting spending. In this light, fiscal measures are merely a part of a larger package of structural reforms needed to make the Euro Zone’s economy more competitive and resilient. This is a message for the periphery and the core, and given the low level of public and private investment, in France and Italy as well as Germany, all euro zone member states have some homework to do.
hopes that the package of measures announced in the past few months will finally assist the fragile recovery more effectively. Comprised of targeted longer term refinancing operations (TLTROs), extremely low nominal interest rates, and the promise by the central bank to buying sizable amounts of asset backed securities (ABS), the package is an effort on the ECB’s part to increase banks’ lending to the real economy. The longer term goals is to revitalize the securitization of assets and ween off the euro zone from its over reliance on banks for credit intermediation.
This is how it would work: If the current comprehensive balance sheet assessment of banks undertaken by the ECB and European Banking Authority (EBA) is successful, the package of TLTROs and low interest rates could incentivize institutions to start extending more loans to the real economy, package them into ABS, and then sell those securities to the ECB. Given the small size of the ABS market in the monetary union—not least because of the stigma attached to ABS after the outbreak of the financial crisis—the ECB needs this market to grow substantially. Ultimately, Europe needs stronger capital markets and a smaller but healthier banking sector. The ECB is trying to do what it can to get there.
Draghi chose the central bankers symposium in Jackson Hole to point out that the ECB and the U.S. Federal Reserve (Fed) are increasingly on divergent paths. While the Fed is likely to tighten monetary policies as economic activity in the Unted States gets stronger, the ECB loosens its monetary policy stance even further. One notable consequence of such divergence is the weakening of the euro. According to Goldman Sachs’ estimates, it could even reach parity with the dollar within a two years. Indeed, the euro zone needs a cheaper currency in order to import inflation and export cheaper goods and services into the global economy. But the goal of readjusting exchange rates can only be achieved if the Fed plays along. The outcome of the Federal Reserve’s FOMC meetings in the next few months will tell us whether that will be the case.
Finally, it will be hard for the Bundesbank or the German government to challenge today’s decisions of the governing council. Recent data indicate that Germany too has hit a soft patch. It needs its partners to recover fast. Otherwise the economic slump could envelop the German economy as well. Still, I don’t expect the German government to criticize Draghi. Some backbenchers probably will, but that is politics, not a real threat to the ECB’s recent actions. Once again Draghi has opened a new phase in the euro area’s efforts to finally overcome the worst crisis in its still young history.