ECB, QE, when yields are low: quantitative fine-tuning

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Senior ECB officials have become increasingly vocal in recent weeks about the European central bank’s ability and willingness to take, if economic conditions require, non-conventional monetary policy measures. These could include negative deposit rates, new types of long-term refinancing operations or even quantitative easing (QE, or, in plain English: “printing money”).

The market has quite rightly welcomed this and indeed is even frustrated as to why quantitative easing is not being introduced straight away. There are economic and technical reasons for the ECB to take its time. As to the former, it may wish to keep its powder dry or it may be hoping that with the pick-up in economic activity, concerns over the possible negative consequences of low inflation will fade away. On the technical side, different elements may be playing a role:

1. A reluctance to embark on QE in view of the sheer amounts involved. Reuters (http://www.reuters.com/article/2014/04/04/ecb-qe-faz-idUSF9N0HR01520140404)  reported recently that ECB staff had calculated it would take EUR 1 trillion to boost inflation by between 0.2 and 0.8 percentage points.

2. Current valuations of bond markets are already high, so pushing them even higher is a challenge. This is a real issue. Financial markets have become so interwoven globally that the direction of government bond yields in the major economies is to a large extent driven by one single component, the impact of the global business cycle on expected inflation, and hence expected monetary policy. This determines whether yields move up or down. Admittedly, domestic factors also play a role – they explain why, for example, yields in Germany are lower than in the US, but higher than in Japan. The correlation in yields (the extent to which they move up and down together) is nevertheless high. In this global business cycle, the US plays a key role by the sheer weight of its economy, but also by the depth and liquidity of its capital markets. These arguments are largely applicable to the direction of the main equity markets as well. An inevitable consequence is that US quantitative easing has had global repercussions: European high-yield spreads (the difference between the yield on lower-quality corporate bonds and sovereign paper) would be higher in the absence of US quantitative easing. The same applies to emerging market spreads and to the valuation of stock markets as shown in their price/earnings ratio. This would pose a challenge for the ECB if it were to decide to embark on QE. Indeed, such a policy has a maximum ‘bang per buck’ (though in this case, one should say ‘bang per euro’) when asset prices are low: QE will, directly or indirectly, significantly boost the value of bonds, equities and real estate, thereby creating wealth effects, which in turn stimulate spending. Today, bond prices are high, which means that German yields, the reference in the eurozone, are very low; corporate spreads, across the quality spectrum, are very low; sovereign bond spreads between eurozone members are also very low. Hence, it is not clear to what extent QE by the ECB would succeed in pushing yields down further (and prices up). One can even question whether it would be a good idea. Would there be a concern about creating bubbles in bond markets?

3. There could be doubts about the size of the wealth effects.

4. There could be doubts about how much of an impact it would have on the euro. Should the euro ‘refuse’ to weaken a lot (e.g. because foreign appetite for European assets had been whetted by the ECB’s action), boosting inflation would almost entirely depend on higher spending.

For all these reasons, the ECB may prefer a very selective type of QE, seeking to influence growth via the credit channel rather than via wealth effects or the currency. In this respect, it was instructive to hear Mario Draghi, in his news conference after the governing council meeting on 3 April, emphasise the need to revive the market in asset-backed securities (backed by bank loans). Yves Mersch’s speech on 7 April on “Banks, SMEs and securitisation” (http://www.ecb.europa.eu/press/key/date/2014/html/sp140407.en.html) is equally important: he makes a plea to develop the securitisation of banks loans to small and medium-sized enterprises.

Indeed, if the ECB were to buy asset-backed securities backed by loans to SMEs, this would allow banks to grant new loans, which in turn would boost growth expectations for the eurozone, in both the short and the long run. Compared with US-style quantitative easing, such a policy should perhaps be called “quantitative fine-tuning”, but its effectiveness in boosting growth and equity markets could still be considerable. The impact on inflation would be slow to materialise, but that is not issue as long as growth accelerates.

William De Vijlder

Group Chief Economist

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