Has the ECB lost faith in QE?

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The ECB kept its monetary policy completely unchanged despite continuing to predict that inflation will undershoot its goal and admitting that the lack of a rise in underlying inflationary pressure was a ‘concern’. This raises a number of questions. Has the ECB lost its faith in QE? Is QE doing more harm than good? Should the ECB adopt another strategy completely?

Though difficult to estimate the precise impact, it does seem likely that the ECB’s policies have had a positive effect. Nick Kounis Nick Kounis Head of Macro Research

  • ECB keeps policy unchanged despite low inflation outlook…
  • …it still sees positive effects of QE though effectiveness is diminishing
  • Calls for governments to act seem futile…
  • …while ECB policy regime change looks unlikely
  • A technology shock would save the day but short of that…
  • … we are stuck in a low growth, low inflation, low interest rate world
  • …making the eurozone vulnerable to the next economic shock

Draghi talks up impact of ECB policy

Listening to ECB President Mario Draghi one would think QE (and the central bank’s other unconventional policies) were the best thing to happen to the world since the discovery of electricity. He made a number of claims about the positive effects these policies were having. They had led to lower interest rates on loans and credit was now growing. In addition, the ‘fragmentation’ in the eurozone – with sharply different credit conditions in different countries – was ‘over’. Mr Draghi even had some estimates of how well the policies have worked. Over the period 2016-2018, the ECB estimates that monetary policy will boost economic growth by a cumulative 0.6% and inflation by 0.4%.

Though maybe actions speak louder than words

Well that begs the question if the policy works so well, why not do more of it to get economic growth and inflation up? Does the ECB’s inaction suggest that it does not really believe in this story? Well the answer to that question is not black and white. The ECB often moves slowly because of the need to gain consensus in the Governing Council. Indeed, it signalled in the press conference that it was moving towards a further easing of monetary policy later in the year. Indeed, Draghi’s assertion that the Council had tasked committees to look into the options seems to be designed to buy some time to build a shared view of what to do.

On the other hand, it does seem that the ECB is reluctant to seriously step up its monetary easing from here. A very large easing package or ‘bazooka’ does not seem on the cards. Rather, we think an extension of the time horizon of the programme (from March to September 2017) and options to increase the pool of assets it can buy seem more likely. This would represent a relatively cautious policy response. It could be argued that given the economy is not exactly collapsing that a more aggressive response is not necessary. However, it probably also reflects a sense of the limits of the policy as well.

Diminishing returns to QE

Though difficult to estimate the precise impact, it does seem likely that the ECB’s policies have had a positive effect. However, it also seems that the policies will be less effective going forward, at least under the current design. QE seems to work best when asset prices are at depressed levels. In that case, asset purchases can have a big impact in pushing down bond yields, and supporting assets such as equities. This leads to a major easing of financial conditions, while the signalling effect also boosts confidence. The Fed’s first QE programme in early 2009 was a good example of this. However, if asset prices are elevated and bond yields are at record lows, QE becomes like trying to get juice out of an already squeezed lemon. You can get some, but it becomes more difficult and you get less juice for your efforts.

Limits to negative rates

There are also limits to the ECB’s current negative rate policy. As in the case of QE, negative rates have helped to bring down bank lending rates. However, the danger is that because banks cannot adjust deposit rates as much, there will be a profit squeeze. This has not happened yet on an aggregate level (the so-called net interest rate margin of banks is still stable). However, the deeper negative rates go, and, or, the longer they stay negative, the more likely banks will feel the pain. This could have adverse effects on the cost and availability of loans.

So overall, it looks as if the ECB’s policy has had a positive effect, however there are limits going forward. That may be a contributing factor to the ECB’s caution. So Mr Draghi still seems to be a believer, but maybe some doubts are creeping in about how aggressive the policies should be going forward.

A new strategy for the ECB?

Low inflation and low growth may be unsatisfactory but are not a disaster. However, the problem is that the current situation means that the eurozone is very vulnerable in case of shocks. In 2008, when the financial crisis hit the economy, core inflation was in line with the ECB’s price stability goal (just below 2%) and the ECB’s key policy rate was at around 4%. Now core inflation is at 0.8% and the key policy rate is -0.4%. A new shock could leave the eurozone heading for deflation without much it could do about it. Of course the ECB will be creative in an emergency, and could look to buy other assets such as equities or even unsecured bank bonds. However, there are also risks to these options and limitations to the impact they will have.

So a new pre-emptive strategy is needed. The ECB seems well aware of this but seems to be putting the onus on governments to act. It has become increasingly vocal in calling for governments to implement structural reforms. These would raise the economy’s long-term growth potential, helping to counteract some of the effects of ageing. It would also then lead to a higher ‘neutral’ or equilibrium interest rate. It has also started to call for governments to increase infrastructure investment, which would essentially have the same effect (if properly targeted). These calls are obviously sensible. However, not very realistic. Mr Draghi and his colleagues may as well be talking to a brick wall.

That means the weight of achieving economic objectives remain with the ECB. Monetary policy obviously has limitations. In cannot raise the eurozone’s long-term growth potential. However, a new policy framework could give the ECB more room for manoeuvre in the future. A higher inflation target for instance would also raise the long-run neutral interest rate in nominal terms. The trouble is that raising the inflation target would only work if it is credible. Companies, households and investors would need to believe that the ECB could achieve the higher target even though it is not meeting its current lower one. To have a chance to make it credible, the ECB would need to be able to promise fresh aggressive monetary stimulus backed up by fiscal policy. This does not seem likely. In any case, the ECB does not seem anywhere close to considering a regime change in terms of its policy framework.

Hoping for a gift from heaven

When people are in a desperate situation they often hope that something falls in their lap from the heavens. Such as a lottery win. The economic equivalent for macro policymakers would be a new technology shock, which lifts the economy’s long-term potential. Well let’s keep our fingers crossed! But short of that, it seems we are stuck in a low growth, low inflation, low interest world, making us vulnerable to the next economic shock.

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