FAQs on the ECB quantitative easing
Much was and is still written about the ECB QE. Instead of adding to the existing prose, and being poor on poetry, I present my view as answers to eight Frequently Asked Questions.
1. Are yields on government securities too low for QE to be effective?
I think the answer to this FAQ comes from inverting the question: yields on government securities are so low because QE has been effective.
2. How can the impact of the program on financial variables be measured?
One first gauge is the spread between 10 year German Government bonds (Bund) and 10 year Italian Government bonds (BTPs). Banca d´Italia estimated in Nov 2012, when the spread was 310 bps, that the fair spread was around 200 basis points. In a recent post with a colleague from Pictet Banque, we reduced this to 180 basis points. The current spread of around 130 bps reflects a number of developments that took place after QE began and therefore cannot be taken as such as a precise indication of the effect of QE. My subjective reading of developments in anticipation of QE and in its aftermath is that the overall effect of QE on the BTP-Bund spread can be estimated at around 60 basis points. The spread gauge, however, overlooks the effect of QE on the bund yield, which also came down after the QE announcement, but increased then sharply more recently. Adding this effect, the overall impact of QE can be estimated, in my view, at around 80 basis points.
3. Have we seen all the effect of QE on financial variables?
My sense is that the market had all the time to adjust to QE and we should not expect much more to come from QE as far as financial variables are concerned. These keep of course moving, indeed sharply as we see these days, but for reasons other than QE. Notice that I do not here include inflationary expectations derived from financial contracts (say from inflations swaps) among financial variables. See more on this below.
4. Will the ECB be able to fully implement its program?
I believe so. Sufficient flexibility has been inserted in the program to avoid early implementation problems. I have in mind in particular the possibility to purchase Agency as well as International Institutions bonds. If going forward problems would appear in implementation, the Governing Council could insert other elements of flexibility in the program. My favourite here is adding corporate bonds to the eligible pool, which could add another 1.4 trillion.
5. How can the effectiveness of the program on macroeconomic variables be measured?
The ultimate test will be whether the ECB will manage to move the European economy back towards the 2% inflation – 2% growth paradigm prevailing before the crisis, as the ECB projects for 2017. Of course, ECB monetary policy is more than just QE and exogenous, non monetary, shocks, will also impact inflation. Still, if the ECB would substantially miss its 1.8% projection in 2017 there would be doubts about the effectiveness of QE. But what does the market think about inflation going back towards 2.00% in 2017? I mentioned above that I did not consider inflationary expectations based, say, on inflation swaps, as a pure financial variable. This statement is not obvious since these expectations are clearly derived from financial prices. Still we do not know enough about their formation to have a firm view on them. For instance, somewhat illogically, long-term inflationary expectations seem to depend on the oil price today. In any case, market derived inflationary expectations are still not fully consistent with a recovery of price stability in the medium term, as they increased somewhat recently but remain distant from 2.00%. Overall it`s too early to assess the effect of QE on inflation.
6. Will the ECB stop the program before September 2016?
The ECB will stop, or taper, its program before September 2016 only if it will be convinced that there is a risk of inflation exceeding the target, say if inflation in 2017 was expected higher than 2.5%. Only this would warrant the monetary policy tightening implicit in disappointing market expectations that the program will last until September 2016.
7. Will the ECB prolong the program after September 2016?
Symmetrically, the ECB will prolong its program only if it would see that its projection of a recovery of price stability is not fulfilled.
8. Was QE the last weapon in the ECB panoply of measures?
I noticed recently a statement by the ECB saying that the “Governing Council has now deployed almost the full range of instruments at the disposal of monetary policy.” I am not sure which additional instrument the ECB has in mind. I know, however, what I have in mind: interventions on either the inflation swap market or the market for inflation options. As I illustrated in a post on my blog with a former colleague, the ECB could, for example, offer contracts whereby it would pay a given sum to its counterparty if inflation was lower than a certain strike price.