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.
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.
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.
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.
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%.
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
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.
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
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.
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.
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.
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.