To infinity and beyond: ECB's quantitative easing

October 02, 2019 08:53
There is a strong case for the ECB’s latest policy action, partly to provide insurance against the damage US trade policy is doing to business sentiment. Photo: Reuters

There was unanimity across the European Central Bank Governing Council on the view that fiscal policy should become the main tool in providing support to the eurozone. This was president Mario Draghi’s answer to the first question at an earlier press conference regarding the “chemistry” in the meeting. With monetary policy increasingly stretched to its limits, it was also the first time he was so direct about the need for fiscal policy to become the main engine of stimulus. Crucially, the ECB’s latest package gives European governments the leeway to loosen the purse strings.

The Governing Council lowered the deposit rate by 10 basis points to -0.5 percent, and introduced tiering to cushion the blow for euro area banks with excess reserves, chiefly in the north. It also eased terms on its TLTRO III funding program, which should support banks in southern Europe.

Most important was the change in its forward guidance and the open-ended nature of its renewed QE program. Interest rates will remain at present or lower levels until core inflation reaches 2 percent and stays there.

What is more, the ECB will start buying assets at a monthly pace of 20 billion euros (US$21.85 billion) as of November, and until it starts raising rates again. This, on top of the rolling over of maturing debt, should be more than enough to absorb net sovereign debt issuance next year, putting a lid on bond yields.

Over the medium term, this also implies that governments should be able to finance themselves for close to nothing. This means that even under existing European rules, with structural budget balances to respect, Draghi’s latest package should free up some fiscal policy space.

Euro area GDP seems on track to grow at a modest 0.2 percent quarter-on-quarter in the third quarter, unchanged from the last quarter. We continue to see a wide gap between indicators related to external and domestic demand, which remain reasonably resilient given the strength of the labor market.

Loose financial conditions are helping too. The pace of real money supply and credit expansion has actually picked up over the past year and corporate credit spreads remain low. These conditions are typically associated with stronger growth, not with a downturn. As we noted previously, the risk of a euro area-wide recession taking place over the next six months remains quite low.

Still, there is a strong case for the ECB’s latest policy action, partly to provide insurance against the damage US trade policy is doing to business sentiment. More fundamentally, German manufacturing is likely to remain under pressure as consumers shun diesel cars. The uncertainty over Brexit is set to persist well into next year, further depressing UK business investment and the demand for German capital goods.

There are already clear signs that manufacturing woes are spreading to the broader economy: euro area employment intentions have deteriorated and optimism about the coming year in the services sector fell sharply in August, according to the latest PMI survey.

The ECB is now lending a helping hand to fiscal authorities to reflate the economy.

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International Economist, Bank J Safra Sarasin