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Next Steps for the European Central Bank

November 14, 2016
In light of the upsets in the global markets after the shocking victory for U.S. President-elect Donald Trump, Europe is once again moving toward extending its unconventional monetary policy. Specifically, the Quantitative Easing program, in hopes of providing stability to the economy in uncertain times. This policy began around October 2014 as a response to the 2008 financial crisis and 2009 European sovereign debt crisis, with the President of the European Central Bank (ECB), Mario Draghi, quickly announcing a massive expansion to the asset-purchasing quantitative easing program in January 2015. In this article, we will showcase ECB purchasing data versus interest rates, inflation rates, and ECB Balance Sheet increases, and will examine the program’s ability to improve the economy.

The Goals of Quantitative Easing

Quantitative easing (QE) is an economic program in which the government purchases securities with electronic money, augmenting bank reserve assets by the quantity of assets purchased. By principle, the QE program encourages banks to grant loans. The ECB’s recent expansion promised potential subsidies to lenders, interest rate cuts, and increased bond purchasing as the QE program’s purpose is to keep inflation rates marginally below 2% and increase money supply over the medium term. New protocol has been instated to complete monthly asset purchases of €60 billion, comprised of €6 billion in public sector purchases, €10 billion in covered bonds and asset-backed securities, and €44 billion in sovereign debt securities. However, the ECB has yet to deliver its promise of leveling the inflation rate near 2% and lack of investment over the QE program’s lifespan has curtailed economic recovery. International Monetary Fund (IMF) economists have cautiously approved the expanded QE program, yet have pointed to the ECB’s history of reducing interest rates below zero as a possible concern. However, economists look ahead to the future of QE and suggest relying more heavily on the purchases of assets.

The State of the Euro Area

<em>(Source: <a href="http://www.economist.com/blogs/graphicdetail/2016/02/taking-europe-s-pulse" target="_blank">The Economist</a>)</em>(Source: The Economist)

Currency circulation growth has remained constant and positive since 2002 to present day, however, growth in the amount of securities the ECB buys is outpacing the growth in currency circulation. Annual interest rates for overnight debtors and creditors follow a general trend: interest rates fell between 2002 and 2003, stayed stagnant or had little growth through 2006, increased nearly 2% from 2006 until 2009, plummeted in 2009 by nearly 3%, and continue to gradually fall to below zero levels. The fixed interest rate follows the same increase until 2001, steadily declined 0.5% over 8 years, and then continued to plummet to near-zero levels as of today. The ECB now faces 0% interest rates for fixed rates.

<em>(Image: Rates for the Euro Area from 2005-2016. Source: <a href="https://fred.stlouisfed.org/series/INTDSREZQ193N" target="_blank">International Monetary Fund</a>)</em>(Image: Rates for the Euro Area from 2005-2016. Source: International Monetary Fund)

The value of debt securities the ECB and its member NCBs are holding is already at the €160 trillion level, while the currency in circulation within the ECB is slightly over €80 trillion. In the Eurozone overall, there is a total of €1,800 trillion worth of debt securities currently being held and total currency circulation of around €1,200 million.

<em>(Image: Central Bank Assets for Euro Area. Source: <a href="https://fred.stlouisfed.org/series/ECBASSETS" target="_blank">European Central Bank</a>)</em>(Image: Central Bank Assets for Euro Area. Source: European Central Bank)

In 2012, the value of the ECB’s assets spiked while the amount of debt securities being held by the ECB and the broader Euro area stayed stagnant. The period between 2012 and 2014 marks an overall decline across all trends: the value of total assets dropped to near pre-2012 levels, the interest rate began its present downward trend, the debt securities the ECB held diminished, and the inflation rate plummeted eventually approaching 0.6%. Post-2014 trends show the growth in the amount of debt securities purchased skyrocket, with the inflation rate achieving positive growth above zero. Despite these significant fluctuations in inflation rate and the amount of purchased debt securities by the ECB, the growth rate of currency in circulation has remained constant.

<em>(Image: Euro Area inflation from 2000 to 2015. Source: World Bank)</em>(Image: Euro Area inflation from 2000 to 2015. Source: World Bank)

QE in the US, UK, and Japan

While the ECB’s program of QE is not the first of its kind, its implementation and associated consequences strongly differ from the actions of other developed economies. The United States Federal Reserve ended its fourth round of QE in October of 2014, following QE1, QE2, and Operation Twist to revitalize the depressed American economy. By purchasing bundles of government bonds and mortgage-backed securities (MBS), the Federal Reserve successfully normalized inflation to 1.46% over 2016, and stock prices have returned to pre-crisis averages. Thus far, few negative consequences of the increased government balance sheet have surfaced regarding dramatic increases in inflation or a lack of available equity for new businesses. The U.S. has not resorted to more drastic policies such as negative interest rates and the Fed is expected to raise rates towards normal levels in 2017. Similarly, the Bank of England’s (BOE) program of purchasing €60 billion of British government-issued bonds per month has experienced varied success in reaching target levels of inflation, while matching the government’s goal of reducing the yield on long-term government debt by 0.2%.

Both the U.S. and the U.K. achieved their goals of revitalizing their respective economies by promoting riskier assets through reverse auctions, a program that is still being implemented within the Eurozone. However, this program has led to concerning consequences for the Bank of Japan (BOJ), in that their 15-year QE program has reached the end of the line. The IMF estimates that continuing purchases of over 750 billion USD of government bonds will have little impact by 2018, as the market to sell these bonds back to the government is drying up. As a result, the BOJ made the alarming decision to continually decrease interest rates below zero in real terms to -0.1%in January of 2016. The government has stated that this will continue until the target inflation rate of 2% is reached from the current deflationary period of -0.5%. The dramatically different level of success from QE in Japan signifies that this policy is limited in scope, as the 15-year program of the BOJ differs strongly in implementation from similar QE schemes elsewhere. The Eurozone must now decide whether to expand or contract its own QE program, and certainly should consider the varying degrees of success among other developed economies.

Efficacy of Quantitative Easing

As discussed above, the Eurozone faces two main problems that are slowing down its economic recovery, namely low investment spending and low inflation. To combat both of these negative effects, the ECB implemented QE among other policies. The question remains: is QE effective?

Many economists have come to believe that the Eurozone is in a safety trap, meaning that there is excess demand for safe assets. This excess demand in turn causes low investment and consumption spending, thus explaining why investment is not back up to the pre-financial crisis level. Before the crisis, the excess safe asset demand could be offset by decreasing interest rates. Following the crisis, the Eurozone interest rates have fluctuated around zero, and with inflation at only 0.4%, it becomes increasingly difficult to bring down the real interest rate (the nominal rate less inflation). The “trap” part of the safety trap is because the low inflation is in many ways cyclical. Low inflation causes an increase in real interest rates, which in turn causes more low inflation, making it difficult to increase economic growth.

Taking all of this into account, the success of quantitative easing as a policy relies on several key factors. First, quantitative easing policies typically substitute one type of safe asset for another, usually money for government debt. Thus, QE does not generally increase the supply of safe assets, therefore aggravating the safe asset supply shortage. Second, for the typical QE policy to work investors must swap their government debt and money for riskier corporate debt; however, if Europe is in safety trap, then this swap would never occur since investors are risk averse.

To combat this, the EU has been using QE to purchase risky private assets. Currently, the expanded Asset Purchase Programme (APP) is the main part of their QE program. In the words of the ECB it “includes all purchase programmes under which private sector securities and public sector securities are purchased to address the risks of a too prolonged period of low inflation.” The purchasing of asset-backed securities attempts to combat the low supply of safe assets by “increasing the net volume of safe assets” in the short run.

Political Implications

This purchasing program is expected to continue through March 2017 at the very least, with continuation to be reevaluated again at the December 8th, 2016 meeting. Especially in the wake of an unexpected Trump victory, the financial markets are faced with uncertainty, making a continuation of QE seem even more inevitable. With these increasingly volatile international markets, the ECB is determined to use stimulus to support the recovery and stability of the Euro Area. The hope is that by satisfying the demand for safe assets, investors and banks will move to include more risky assets in their portfolio, thus encouraging investment and consumption—both necessary precursors to a healthy economy. As we can see, this program was initiated in November of 2014, but the low investment and low inflation that characterize the Eurozone economy continue to persist. However, many economists, including many at the IMF, have continued to encourage the ECB to expand the QE purchases if inflation remains under target. Keeping this in mind, it is important to remember that QE is one monetary policy tool of many, and in order to fully recover from this crisis the ECB must use all of the tools at its disposal.

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