Financial markets were positively surprised by Mario Draghi's recent announcement who declared that the ECB is assessing its current program of Quantitative Easing (QE). European stock markets went up significantly. The Dax increased by more than 7% and the Euro Stoxx 50 went up by almost 6% over the course of last week. The euro depreciated by about 3 percent versus the dollar, falling back to a 3-month low of 1.10. One should emphasise that U.S. stocks also went up when the news came out, thus disproving the beggar-thy-neighbor theory, which never made too much sense anyways. Despite an appreciation of the dollar (vis-a-vis the euro), higher demand in the Eurozone is also good news for the U.S. Currency deprecation arising from loser monetary policy do not simply shift demand around from one economy to the other, but lead to higher in the Eurozone and thus also for the world as whole. Looser monetary policy by the ECB is also somewhat beneficial for the U.S. economy as the demand for U.S. goods and services increases.
The strong reactions of financial markets show that monetary policy can still be highly effective even if interest rates are at the zero-lower bound. In normal times Central Banks are using the interest rate as a policy tool to keep the nominal economy on track. However, ever since the financial crisis they had to rely on a variety of alternative instruments because interest rates are stuck at zero. Many Central Banks, such as the FED and the Bank of Japan, have implemented large programs of asset purchases to stimulate the economy. The basic idea is to increase the amount of base money in the economy. An increase in the money supply will ultimately translate into higher prices and more economic activity. That is because economic agents are trying to get rid of the additional amount of base money that is now in the system. More money leads to more spending on good and services, which will eventually also increase the inflation rate.
One should be aware that QE also works through various other channels. The most obvious one is the wealth effect. QE has increased the price of numerous financial assets, such as stocks, bonds, and housing. Part of the newly created wealth will be spent on goods and services. The depreciation of the exchange rate is also stimulative because it raises inflation expectations. Economic agents will decide to get rid of some of their money hoardings as they expect a higher inflation rate and this in turn will stimulate economic activity. The most important channel, however, works through expectations. The mere expectation of higher growth and inflation in the future will stimulate spending and investment today. For that reason, monetary policy makers must be able to guide expectations, a task they have poorly managed ever since the onset of the financial crisis.
So even the mere announcement that the ECB is looking into additional monetary easing has had a large impact on financial markets and is stimulative to economic activity. This demonstrates that Central Banks still have more than enough firepower even when constrained by the zero-lower bound, providing that they are willing to use alternative policy instruments.
The economic stagnation in the Eurozone has been going on for almost a decade now and some countries now fare worse than they did during the Great Depression. It is truly amazing (in a bad way) how policy makers in industrialised countries, especially in Europe, repeated most of the mistakes that were made during the 1930s. The economic malaise in the Eurozone is mostly due to a toxic mix of highly restrictive fiscal and monetary policy. Having the Euro is in many ways similar to being on the gold standard. However, industrialized countries eventually recovered from the Great Depression by abandoning the gold standard and pursuing highly expansionary monetary policies. The situation for some Eurozone members is to some extent even more dire. They have to stick with the common currency because leaving the euro would trigger the “mother of all finical crises” (Barry Eichengreen). The Eurozone countries obviously lack their own monetary policy, which is determined by the ECB. American economists predicted even before the creation of the euro that the “one-size-fits-all monetary policy” would lead to an economic catastophe. They were right. Ever since the crisis monetary policy was extremely tight, especially in Southern Europe, but also for the entire currency bloc as a whole.
The ECB finally decided to move towards a more accommodative monetary policy by March 2015 when it finally started its own program of Quantitative Easing years after similar policies had already been implemented in the U.S, the UK and Japan. The ECB announced in the beginning of this year that it would make monthly asset purchases of about 60 billion euros, mostly government bonds from member countries, with a total size of the QE program would be at least 1.1 trillion euros. The asset purchases started in March and are expected to last until September 2016.
However, the recent economic slowdown over the summer has led to an effective tightening of monetary conditions. It is now clear that the current purchases are not sufficient to bring inflation back to the ECB’s inflation mandate of 2 percent. Weak aggregate demand and the persistent undershooting of the inflation target clearly indicate that further monetary easing is necessary.
So here is what the ECB could do in order to loosen monetary policy even further.
- It could increase the size and the duration of the asset purchase program.
- It could change the composition of the asset purchase program and decide to financial assets other than Eurozone government bonds.
- It could decrease the deposit rate (currently at negative 20 basis points) even further so that banks get charged even more if they have deposit reserves at the ECB. The deposit rate in Switzerland is at - 0.75%, for example.
- The ECB could change its currently flawed mandate of 2% inflation and aim for a 4% inflation target, or even better, a nominal GDP level target.
The ECB’s 2% inflation target is pretty much set in stone and policy makers don’t have the balls to even address the problem of a flawed policy target. But some of the other propositions are likely on the table so that they can finally hit their own target again after several years of undershooting.
Draghi actually did not explicitly rule out a move into even more negative territory when it comes to the deposit rate and I would very much welcome such a policy change. More likely is, however, is an extension of the asset purchase program. I am not quite sure whether they are willing to increase the monthly purchases from about 60 billion euros now even though this would be highly desirable. Probably they will simply extend the length of the program. They might also consider buying other financial assets because at the current pace they are going to run out of Eurozone government bonds to buy in a few years as austerity decreases the amount of debt outstanding.
I have explained before that it would make a lot of sense for the ECB to buy American government bonds (http://macrothoughts.weebly.com/blog/buy-american). The market is highly liquid and the purchase of assets in foreign currency would depreciate the euro by more than an equivalent purchase of domestic assets. The larger depreciation would have a stronger effect on inflation expectations (as the price of imports rises more steeply), which in turn would boost aggregate demand. Some foreign governments would, however, might not like the idea of direct currency interventions and there could be a move to more protectionist policies even though higher demand in the eurozone would be a plus for the global economy as a whole.
To conclude, the Eurozone desperately needs further monetary easing. The answer to the question in the title is thus: Do Q.E., and lots of it!!!