Thursday, January 15, 2015

ECJ ruling opens the door to QE - but will it work?

For a quantitative easing program to be in any way effective in the Euro zone it must be large and unconstrained.  Up until now there have been two potential constraints to an effective asset purchase program – opposition from the German Bundesbank, primarily on the issue of risk sharing, and a pending ruling from the European Court of Justice (ECJ) on the legality of the earlier Outright Monetary Transactions (OMT) program.

Overnight the ECJ issued a non-binding opinion that, subject to a number of small conditions, the OMT is consistent with the EU Treaty.  Furthermore the opinion stated that the ECB should have “broad discretion when framing and implementing the EU’s monetary policy”.  Couldn’t agree more.

A final ruling from the ECJ is due in a few months but it seems unlikely will be substantially different from this opinion.  In the meantime this has removed any legal barriers to the announcement of a sovereign debt purchase program by the ECB on January 22nd. 

During the course of last year the ECB took a number of steps to support the flagging economy and to boost persistently low inflation.  They cut interest rates (including the introduction of a negative deposit rate) and launched the TLTRO, the take-up of which has been disappointingly low in the first two tranches.

Since then core inflation has continued to drift lower to a level that is uncomfortably low, a reflection of a persistently large output gap best indicated by an unemployment rate that remains chronically high at 11.5%.

The oil price fall has added to the disinflationary forces at play within the euro zone which is now in (technical) deflation.  While orthodox monetary policy suggests the ECB should look through the oil price shock, broader disinflationary forces are already well entrenched.  Furthermore it seems the oil price fall has greatest chance of spilling over into core inflation in countries where demand is weakest.  The euro zone fits the bill admirably.

The ECB rhetoric has stepped-up recently to the extent that a sovereign debt purchase program is now fully priced in by markets, thereby already delivering the decline in bond yields and a lower currency the ECB will be hoping will support growth and bolster inflation.  The risk for markets (and the euro zone economy) is the ECB underwhelms expectations next week.

So expect the ECB to announce a sovereign debt purchase program as part of its commitment to expand its balance sheet by €1 trillion, although some detail is likely to be unresolved.  A QE program in the euro zone is obviously more complex than it is in the likes of the US, the UK or Japan.

The ECJ opinion also reduces the effectiveness of opposition from the Bundesbank which fears the sharing of risk of sovereign bond purchases by the ECB will covertly lead to the introduction of Eurobonds.  I don’t have a problem with that as I still think some form of debt mutualisation is inevitable if the Euro is to survive as a common currency.   That concern can be mitigated if each national central bank to purchase its own sovereign bonds with no pooling of risk.  That seems to me to be a second best solution to large and unconstrained action by the ECB.

But will it work?  The ECB will be expecting the expansion of the monetary base, lower yields and greater liquidity to support rising asset prices to all contribute to stronger credit and GDP growth.  A lower exchange rate are will bolster inflation and add to competitiveness. In that respect it’s a necessary step along the path to higher growth and inflation.

But will it be sufficient?  Probably not.  Have a (re)read of Mario Draghi’s speech from Jackson Hole last year and you will see even he thinks monetary policy alone cannot fix what ails the euro zone.  Monetary policy needs mates in the form of growth enhancing fiscal policy and structural reform, especially in the labour market.

I’m often asked whether QE worked in America.  Apart from the obvious impact on interest and exchange rates, the important contribution it made was to buy time for the economy to heal itself.  But that was in the most flexible, nimble, innovative, dynamic economy on the planet.  The euro zone doesn't have that luxury.