ECB set to deliver

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Mario Draghi

We think that President Mario Draghi will announce that the ECB will embark on a large scale asset purchase programme, including government bonds, at next week’s meeting. In this edition of the weekly, we ask eight big questions about the outlook for the monetary policy and the impact on financial markets, the economy and inflation.

The impact of QE on the economy will be positive. The decline in the euro will lift growth. Nick Kounis Nick Kounis Head of Macro Research

Will the ECB announce QE already this week?

Yes. For a long time it seemed like a close call between whether the announcement would be in January or March. However, a number of factors appear now to be pointing to a move next week. A number of officials have suggested that the central bank is ‘ready to act’ and that it should not wait too long in acting.

In addition, the European Court of Justice appears to have given the ECB a green light to embark on QE in its early opinion on government bond buys via the OMT programme.

Finally, the sharp fall in oil prices, which has driven inflation into negative territory, seems to have increased the ECB’s urgency to act. Of course lower oil prices are great news for economic growth and a central bank usually ignores oil price swings. However, given that inflation is already so far from its goal, the central bank is worried about its credibility.

What will the ECB buy?

We think that President Mario Draghi will announce that the ECB will embark on a large scale asset purchase programme, which will mainly consist of sovereign bonds, but could also include other debt securities such nonfinancial corporate bonds and agency debt.

There are indications that the ECB will decide to limit its purchases to investment grade bonds. This would exclude a small number of member states, including Greece from the main programme. It would be natural for sovereign bond buys to be allocated between countries using the capital key.

An investment grade plan could be convenient for the ECB given the Greek elections and the aim of Syriza, the main opposition party that is ahead in the polls, to restructure Greek debt. An alternative is that the ECB could decide to allow the national central banks of non-investment grade countries to buy their own country’s bonds, but then at their own risk.

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How big will the programme be?

The ECB currently aims to increase its balance sheet by EUR 1 trillion, which would take it back to the levels seen early in 2012. There have been media reports that the central bank is considering a government bond programme totalling EUR 500bn. This would be large enough to meet the EUR 1 trillion target if the central bank also launched corporate bond and agency debt programmes alongside the sovereign bond plan and the already announced measures (covered bonds and ABS programmes and TLTROs).

However, if the ECB were to only launch a EUR 500bn sovereign bond purchase programme with no other measures, it would probably be a stretch to achieve the EUR 1 trillion. In addition, the ECB may well need to increase the balance sheet target going forward, given that the inflation outlook has deteriorated since it announced it.

So the risks are tilted towards a larger sovereign bond programme, either next week, or because the ECB follows up eventually with QE-2. We think that the central bank has a strong incentive to surprise positively. However, there is a possibility that the Governing Council takes a more conservative stance because it does not want to upset the more hawkish officials that are against QE.

What will be the impact on financial markets?

The lessons from the US, suggest that a convincing QE programme would tend to boost investor sentiment, leading to risk spread compression. That would mean that equities, corporate bonds and peripheral government bonds would tend to do well. Although a QE programme is now widely expected, the US experience suggests that risky assets do well during the programme as well, as investors search for yield.

The same is true of the exchange rate. During the US QE, the dollar continued to slide during the programmes. We also expect to see ongoing euro weakness, also because monetary policy on either side of the Atlantic is heading in different directions.

What about the ‘ultra-safe’ government bonds of Germany and other core countries? In the US, Treasury yields tended to fall sharply in anticipation of the QE programme, but then rebounded strongly shortly after the actual announcement. We think that German government bonds have also gone a long way in factoring in QE, as yields have fallen sharply and they are probably close to the bottom.

However, we do not expect a sharp or quick bounce back. Unless the programme really beats market expectations, investors will speculate that there may be more to come. In addition, there are forces depressing yields, such as the scarcity of high quality government bonds. We expect yields to remain low in the near term, before rising modestly later in the year.

What will be the impact on the economy?

The impact of QE on the economy will be positive. The decline in the euro will lift growth. We estimate that a 10% fall in the effective exchange rate can boost GDP by around a percentage point after a year. Since the Spring of last year, when it became clear that the ECB would ease policy further, the euro effective exchange rate has fallen by around 7%. We expect it to fall further.

In addition, the compression of risk premiums leads to an easing of financial conditions. The eurozone is a bank-based rather than a market-based economy, so the impact through this channel will be weaker than in the US. However, there will still be a significant effect, with the fall in peripheral bond yields leading to declines in bank lending rates.

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Will the ECB reach the 2% inflation goal?

Probably not for a long time. Somewhat stronger growth and the fall in the euro will raise inflation over time. However, the low starting point (core inflation is at just 0.8%) means that it would take an economic boom to get underlying inflation back to 2% over the next year or two.

Does QE have negative side effects?

Yes. QE can push asset prices away from fundamentals and create the wrong kind of incentives for policymakers. However, balanced out against the positive impulse to demand and inflation, it still looks worth doing. This is especially the case given the risk of deflation, however small.

The support to growth from QE could dull the incentives for eurozone policymakers to take badly needed reforms. However, these incentives unfortunately do not look to be that great right now in any case, and it is unlikely that QE will be the swing factor.

Is QE the answer to Europe’s problems?

No. There is little doubt that weak demand is an issue in the eurozone and QE will help to support demand. However, arguably the bigger problem is that the eurozone’s trend or potential economic growth rate has declined. To lift economic performance over the long-term, governments need to step up structural reforms.


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