Quantitative easing is the last throw of the eurozone dice

7/12/2014

John Plende

For much of this year the equity market story has been about central banks conducting levitation in share prices through the jerky ratchet known as risk-on, risk-off. Investors’ perceptions about whether monetary tightening would come sooner or later have caused markets to twitch up and down, yet the overall trajectory has remained upwards.

The big question has been whether corporate earnings could rise sufficiently to justify the valuation uplift. But since June something real has been going on that greatly improves the prospects for both economic growth and corporate earnings in a developed world that has been suffering from anaemic growth.

The fall in oil prices of more than 30 per cent over that period gives consumers in the advanced economies the equivalent of a tax break at the expense of oil producers. Since advanced countries spend more of their income than emerging market oil producers the outcome is a boost to aggregate demand.

This is a boon, especially in the eurozone, which suffers acutely from deficient demand. Yet many fear that the energy-induced decline in the price level will tilt the eurozone into deflation and put it on to the road to perdition.

I have long been worried that the European Central Bank has been slow to address the threat of deflation. But a fall in energy prices is not a good reason for panic because deflation can be good, bad or something in between.

In the depression of the 1930s it was undoubtedly bad, because it reflected excess supply and deficient demand. In the late 19th century it was good. During the misnamed Great Depression of 1873-96, there was average annual real growth of 2 per cent despite a decline in the general price level, spurred by shrinking land values and falling prices in older industries.

The experience of falling energy prices comes closer to the 19th century example than the 1930s. The problem with a malign deflation is that consumers defer spending decisions because they expect things to become cheaper. Yet history suggests that a rise in real incomes resulting from falling energy prices is more likely to encourage people to spend.

That said, there are other very powerful deflationary forces at work in the eurozone, such as the restrictive German fiscal diktat and an ECB monetary policy that is delivering below-target inflation of just 0.3 per cent. By putting downward pressure on inflation, the fall in energy prices will add to the pressure on the ECB to move to full US-style quantitative easing.

Here, paradoxically, there could be a malign impact. For if the ECB moves to full QE against the wishes of the German members of the governing council, the damage to the ECB’s credibility would be devastating. It is hard to see how the eurozone central bank could operate without the support of Europe’s economic superpower.

Yet if Mr Draghi, the president, does persuade the Germans that the ECB’s legal mandate cannot be fulfilled without QE, it would send a curious signal. The Germans are not alone on the governing council in being sceptical about QE, given the very different financial structure in the eurozone compared with the US. While markets, gripped by a hunger for yield, are currently fired up about the prospect, they would ultimately have to recognise that a move to QE would be a sign of desperation — the last throw of the eurozone dice. Indeed, investors are placing a euphoric bet on a policy of probably limited effectiveness.

To return to energy prices, the big corporate losers will be fracking companies and other high-cost producers. That is a worry for investors in credit, since the energy sector is a big chunk of the high-yield bond and leveraged loan markets. Risk premia in credit markets are already astonishingly low relative to government securities thanks to the search for yield. A rash of energy sector defaults, especially if combined with worries about the ECB’s credibility, could spell the beginning of the end of the great yield mania.

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