BlogSpot - December 15th, 2014

QE keeps center place in the European debate

Delayed action once again… No QE was announced at the latest ECB meeting, despite much anticipation—despite a downward revision in growth and in inflation forecasts. The ECB will continue with ultralow interest rates, a second round of lending operations to banks conditional on lending to non-financial businesses and buying covered bonds as well as asset-backed securities. The Economist blog says these initiatives are unlikely to boost the ECB’s balance sheet as much as necessary. EuroIntelligence agrees that the combination of TLTRO and private-asset purchases will be insufficient to reach the ECB’s €1tn goal without QE.

Take-up in the second T-LTRO auction was low again, at slightly less than 130 billion or 212 billion for both rounds, compared to total LTRO repayments of 990 billion since 2013. Sivia Merler (Bruegel) reports that despite the ECB’s intention of increasing its balance sheet by 1 trillion, excess liquidity in the euro zone is shrinking to record lows. Banks are not helping; data show that banks have taken advantage of September’s TLTRO financing to repay previously borrowed LTRO funds.

Monetary policy in the eurozone remains much tighter than in the UK or the US, as indicated by Zsolt Darvas (Bruegel) based on shadow rates calculations. This reinforces the case for the ECB to act, as developed by Ashoka Mody. Frankfurter Allgemeine (hat-tip EuroIntelligence) reports that recent simulations by the eurosystem central banks estimate the impact of a €1tn QE at an increase in inflation rates at 0.15pp and 0.6pp.

Although… Risks to price stability have increased, as explained by Sylvia Merler (Bruegel)—decling oil prices to 65$ per barrel (see EuroIntelligence); CPI inflation in Germany confirmed at +0.6% for November 2014; French core inflation turned into negative territory for the first time ever… EuroIntelligence provides more details on thisself-reinforcing cycle of falling inflationary expectations. The 10-year inflation swaps are at the same level as in Japan, with even the 20 year swap well below the ECB's target—reflecting a belief that the ECB will not get close to its target for another 10-15 years. The main driver of headline inflation rates now is the oil price.

Disagreement on QE, especially on the board of the ECB. According to EuroIntelligence, those who oppose QE, namely Sabine Lautenschlager and Yves Mersch, seem to cite an institutional, rather than economic, argument—that it is not appropriate in a monetary union with no fiscal transfers.

The adequate design of QE—EuroIntelligence notes that the discussion is moving on the details of QE. Athanasios Orphanides, in a VoxEu article, advocates for implementing quantitative easing with no further delay, with purchases of Eurozone sovereign debt apportioned according to the ECB’s capital key, to account for the relative sizes of the member states whose sovereign debt would be purchased in the secondary market, with a target of reaching at least €4 trillion. Angel Ubide (Peterson Institute) proposes an open-ended program of €80bn per month of purchases of securities with a yield of higher than five years, with the goal to return to the inflation target on a sustainable basis. Silvia Merler suggests that the ECB buy EIB bonds, with no more risk than commercial ABS, and the investment guarantee from the Juncker plan that would allow the ECB to invest in some of the riskier tranches. Jean-Pierre Landau (VoxEU) conjectures that low inflation in the Eurozone results from an excess demand for safe assets, and that getting out of the ‘safety trap’ necessitates fiscal or non-conventional monetary policies tailored to temporarily take risk away from private balance sheets—to increase the net supply of safe assets, through action to improve the substitutability between safe and risky financial assets, through direct and massive purchases of private (risky) assets, and finally through issuing new government debt.

Beyond QE—Adair Turner (hat-tip EuroIntelligence) has a more radical proposal in the form of a full scale debt monetization, i.e., converting the government bonds the central bank owns by a new form of debt which is perpetual and with zero interest. Wolfgang Munchau (Spiegel) writes that large-scale QE is de facto debt monetization. Large-scale means, for Munchau, between €2-3tr, around 25-30% of the eurozone’s sovereign debt, i.e., an imperfect form of eurobond (a hidden, unconditional debt monetization) because of Germany’s veto of a proper eurobond.

Political complications—Alex Waters et al., in Roubini, stress that the European political cycle in the eurozone complicates the economic outlook—with elections throughout the periphery (bar Ireland), and anti-system parties on the rise. Risks to an already weak outlook are on the downside.

The German case and QE feasibility—Reza Moghadam (FT) and Barry Eichengreen (Project Syndicate) write that it may not work nearly as well in Europe, because of political tensions—an effective QE requires the full support of Germany. For Eichengreen, incrementalism will not work, because, when the problem is deflation, quantitative easing will help only by transforming expectations. EuroIntelligence reviews German opposition: Clemens Fuest view that it is indeed akeen to a eurobond that requires the approval of parliaments; Hans-Werner Sinn saying that the ECB would overstep its legal mandate with QE; Volker Wieland writing that QE would discourage economic reform programs. FreeExchange reminds us that the two German representatives on the ECB’s council oppose QE. Marcel Fratzscher stresses that QE would benefit Germany as much as other countries in the region, and suggests that it should be concentrated in countries where the policy transmission mechanism is greatest. While he sees uncertainty about its potential success, he also argues that there are no alternatives.

The Short View… the impact of plunging oil prices on the global economy.

On November 27, the 166th OPEC meeting decided to keep oil production unchanged despite continuously falling oil prices since June 2014 (Rasmus, teleSUR). At the Wall Street Journal CEO Council annual meeting, IMF chief Christine Lagarde argued that the U.S. and Europe will benefit from falling oil prices, while Russia’s economy will suffer (India TV). Yet, the positive impact of OPEC’s agreement on the U.S. and Europe is questionable. In times of nearly zero inflation, the euro zone follows OPEC’s accord with concern—despite the growth impact (Gaunt, Reuters), it increases deflationary worries (Rasmus, teleSUR). Contrary to most experts, the ECB sees the fall in oil prices as a result of both demand and supply side shocks (Financial Times). The Financial Times suggests that the ECB might use this argument as a reason for more expansionary monetary policy.