Many say it’s time for the ECB to ramp up QE. But how to make it work?

September 14, 2015

RTX1QWU5.jpgThat the European Central Bank will have to soon add to its massive stimulus programme is fast becoming the consensus view among economists, although how it will do that effectively is far from clear.

After much deliberation and overcoming staunch opposition from Germany, the ECB launched its 60 billion euro a month bond-buying scheme in March. That was among the last policy options it had left after cutting interest rates to record lows.

It still may be too early to compare the ECB to the Bank of Japan, which on Monday was in the midst of a two-day monetary policy meeting and has been battling bouts of deflation and disinflation over the majority of the past two decades.

But hopes of more stimulus from the ECB contrasts dramatically with policy across the Atlantic.

The U.S. Federal Reserve is meeting this week to decide whether to hike rates in the world’s largest economy – the first such rise in almost a decade. A slight majority of economists predict it will, but nobody has much conviction one way or another.

For the euro zone, however, six months of quantitative easing so so far has yielded few tangible results.

The outlook for inflation and growth in the euro zone remains tepid despite the positive revisions to gross domestic product for the first half of the year. If anything it looks like the best times have already passed.

In Reuters polls last week, the economy was pegged to grow 0.4 percent in each quarter until the end of 2016, while inflation was expected to average only 1.6 percent in 2017 — still short of the ECB’s target of close to but below 2 percent.

Oil prices have begun falling again after a brief pause. Coupled with the euro’s recent strength, that means inflation is likely to head lower.

Financial markets, egged on by ECB policymakers and jittery over the global stock, currency and commodities market rout in August, have been quick to expect more stimulus from the central bank.

So, what is more?

A majority of economists in a Reuters poll taken Sept. 8 – 10 forecast the ECB will officially extend its programme beyond September 2016.

On the face of it that sounds reasonable, except that ECB President Mario Draghi has already said QE would go on until at least September next year and maybe even beyond, depending on the outlook for inflation.

Extending the programme would have little incremental effect in the short-run except to hypothetically load up the ECB’s balance sheet.

ECB balance sheet

Draghi will probably get more bang for his buck by dramatically increasing the size of monthly purchases — which would also help to send a clear signal to markets of the central bank’s intentions to pull inflation higher and spark growth.

That is the second best policy option, however, according to economists. A few of them took a shot at predicting what the new monthly amount would be; the consensus was 80 billion euros.

Still, that is short of what the U.S. Federal Reserve pumped in through the last of its stimulus programmes, leaving aside what it did through numerous schemes before that.

FED

In total, the Fed accumulated $4.5 trillion in assets on its balance sheet, about a quarter of U.S. GDP. Yet the tangible effects of such unprecedented money printing on the U.S. economy are questionable at best.

Almost seven years after the first purchase, the world’s largest economy has just about managed to scrape up enough growth for policymakers to start considering an interest rate hike.

That’s just a little longer than the average duration of an economic cycle during which growth expands and then contracts.

Even if Fed Chair Janet Yellen raises rates this week, future hikes would be spread out with long periods in between due to low inflation, weak pay growth and a strengthening dollar that imports disinflation and hits exports.

The situation is much more dire in Japan — the modern-day pioneer of quantitative easing.

It’s been nearly 15 years since the Bank of Japan first started printing money and its balance sheet has swollen to a staggering 365 trillion yen, about 3/4 th the size of the economy.

But inflation is still nowhere near the central bank’s target and the economy has frequently emerged from recessions only to dip into another one.

Even a forced attempt to raise inflation by increasing sales taxes has failed. Households’ expectations of price rises are also wilting, according to a government survey this month.

For the ECB, going deeper into QE may be the only policy option left no matter how it alters its asset purchase programme, whether in size or duration or both.

But for inflation to rise to near 2 percent, history shows monetary policy may not be enough, unless there is a spurt in demand. But that is possible only if businesses and consumers feel confident enough to spend — no matter what the central bank is doing with its printing presses.

(With additional inputs by Rahul Karunakar)

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