Why the ECB Adopted QE
World Economy

Why the ECB Adopted QE

The European Central Bank (ECB) announced an expanded quantitative easing (QE) program on January 22. Starting in March 2015, the ECB will buy, on a monthly basis, Euro 60b worth of Euro Area sovereign bonds and private sector securities.
The purchases will continue until September 2016, although the program could also become open ended until a “sustained adjustment in the path of inflation” is observed, BI-ME staff said in a commentary published Sunday.
In making large-scale purchases of sovereign bonds, the ECB has (belatedly) joined the three other major central banks (the Japanese, UK and US central banks), which had resorted to QE after they ran out of room to reduce interest rates any further.
If monetary policy were to be reduced to one job, it would be to ensure that temporary shocks to inflation do not become permanent. A central bank can do nothing to stop US oil producers from flooding the market and driving down international oil prices. However, it can prevent lower oil prices from turning into a deflationary spiral.

To Ensure Stability
The key to doing so is to ensure the stability of inflation expectations. If people expect inflation will soon revert to a certain rate (say “below, but close to 2%”), they will ignore the fall in oil prices when they set prices for other goods and wages.
This will ensure that the oil price shock will soon fade away. If, on the other hand, they believe the central bank is unwilling or unable to bring inflation back under control, then the oil price shock can feed into lower prices for other goods and wages, and the shock could ultimately turn into a permanent deflation.
Second, by lowering the yields on government bonds, the ECB may induce banks to lend more to corporations and households, thus boosting aggregate demand and inflation.
Finally, by weakening the euro against other currencies, the ECB’s monetary expansion would increase the price of imported goods and services. Of all these channels, the last one is likely to have the biggest impact on inflation. Since the ECB announcement, the euro has depreciated 3.0% against the US dollar.

Risks Involved
However, there are risks to the ECB strategy. First, bond yields in the Euro Area are already very low. Any QE boost is therefore likely to be limited as it would result in only a few basis points movement in bond yields.
Second, European banks are less likely to respond to QE than US banks did as European corporates are highly leveraged and therefore unlikely to gain from lower interest rates.
Third, by mutualizing the risk of default across the Euro Area, the ECB is venturing into the realm of fiscal policy, which could result in cross-border transfers from northern Europe to the troubled periphery countries. This may also reduce the incentives of periphery countries to undertake the necessary reforms to increase growth and reduce their debt burden.
Moreover, the recent historical experience shows that QE can have large cross-border spillover effects. These effects had already started ahead of the ECB’s decision with the Swiss National Bank abandoning its exchange rate floor and the Danish central bank pushing interest rates further into negative territory in order to maintain its currency peg to the euro.
Emerging markets (EMs) may see some additional capital inflows from the Euro area searching for higher yields. However, what is different this time around is the market expectations of a possible increase in US interest rates later this year. Most likely, the largest Euro area capital flows will therefore be to the US, with a continued strengthening of the US dollar against all other major currencies.
In the end, monetary policy can be powerful in the short-term but is unlikely to change the long-term predicament of the Euro area. The ECB may succeed in preventing prolonged deflation from taking hold, but this is a not a sufficient condition for sustainable growth.


Short URL : http://goo.gl/4tca47

You can also read ...

IMF Says Mongolia Tax Rates Low
Tax rates in Mongolia are low, compared to rates in developing...
The central bank of Thailand in February held its headline interest rate flat at 1.5% and expects the economy to recover at a faster pace in 2017.
Asean members must remain vigilant to ensure a stable 2017...
$7.5b Bailout
Kazakhstan’s state-run “bad bank” will buy 2.4 trillion tenge ($...
Italy Retail Sales Rise
Italy’s retail sales increased at a faster-than-expected pace in...
Russia CB May Cut Rate
Russia’s central bank could consider cutting rates at its next...
US Consumer Prices Rise
US consumer prices rose at a slower pace in February. Clothing...
Households borrowed C$28.4 billion in the fourth quarter,  up from C$18.7 billion in the previous quarter.
Canadian household debt as a share of income rose to a fresh...
Turkey Jobless at 12.7%, Youth Rate at 24%
Turkey’s unemployment rate hit 12.7% in December, rising by 1.9...