Will eurozone QE be too little, too late?

By Larry Elliott

Having ramped up expectations, there is now a danger that the long-awaited sovereign bond purchases will prove a damp squib

For Mario Draghi, Thursday is the day the talking stops. It is two and a half years since the president of the European Central Bank said he would do “whatever it takes” to safeguard the future of the euro. Financial markets now want him to deliver on his pledge.

All the hurdles – economic, political and legal – have allegedly been cleared. The ECB will announce a programme of sovereign bond purchases, its equivalent of the quantitative easing programmes that were announced by the US Federal Reserve and the Bank of England six years ago.

But nothing is ever simple when it comes to the eurozone. So when François Hollande stated earlier this week that the ECB would create a “movement that is favourable to growth” by buying sovereign debt, it was only a matter of hours before the French president rowed back, saying that he was speaking “hypothetically”.

It was not hard to see why Hollande backtracked so quickly. The German government has been dragged kicking and screaming towards this latest attempt to boost activity in the 19 countries that use the single currency, fearful that it will be the citizens of Europe’s biggest economy that foot the bill for any losses from the bond-buying plan.

The signs this week were that Germany’s still massively influential Bundesbank was seeking to limit the scale of the programme and ensure that each eurozone country’s central bank bear the risk for buying its own national bonds. Reuters said on Monday that it had been talking to a source familiar with Bundesbank thinking, who said: “What exactly comes and in what dosage, that’s where the real action is at the moment. It could be that the decision is taken with details to follow.” Few were in doubt that “familiar with Bundesbank thinking” meant a Bundesbank official speaking on a non-attributable basis.

Having ramped up expectations, there is now a danger that the long-awaited plan proves a damp squib. Markets want Draghi to put a figure on the size of his programme (preferably at least €1tn) and they want to know exactly how it will be operated. Given the length of time that has elapsed since Draghi’s “whatever it takes” speech, they will be unhappy with anything less.

In reality, the nature of the challenge facing the ECB has changed since July 2012. Then, the eurozone was facing an existential crisis: the interest rates on the government bonds issued by Italy and Spain suggested that the financial markets foresaw the risk of the single currency breaking up. Today, the problem is more chronic than acute: the eurozone has been gripped by economic torpor ever since the deep recession of 2008-09 and prices are lower than they were a year ago. The risk of a euro break-up is more remote but is still seen as possible if stagnation leads to a persistent deflation that makes the debts of some euro members too expensive to bear. Draghi’s plan is designed to ease the deflation risk.

But it is by no means certain that the ECB will succeed. One fear is that the plan is too, little late. Jonathan Loynes, chief European economist at Capital Economics, said: “It is virtually certain that the ECB will announce some form of quantitative easing (QE) at its governing council meeting on January 22nd. But given the ECB’s natural caution and Germany’s objections, we’re not very confident that the programme will be big and effective enough to revive the eurozone economy or eliminate the risk of a prolonged bout of deflation.”

Others are sceptical about whether QE has worked in the US and the UK, even though the central banks in both countries believe that bond buying has led to both growth and inflation being higher than they otherwise would have been. Dhaval Joshi, of BCA research, said the recent growth and employment differences between the world’s major economies were largely due to fiscal policy – the severity of austerity – and whether governments had facilitated new lending by repairing their banking systems.

“Meanwhile, like-for-like inflation (which requires stripping out shelter costs in the US and the VAT tax hike in Japan) is converging towards the same near-zero level in all the major economies”, Joshi added. “Simply put, the different directions of central bank balance sheets have had zero impact on inflation outcomes.”

In the end, the buying of bonds by a central bank can only work through one of three channels. Banks can use the money they receive in exchange for their bonds to increase lending to consumers and businesses. Purchases of sovereign debt can drive down interest rates because the removal of bonds from the market makes them more attractive. This increases their price and reduces the yield (interest rate) payable on them. Finally, central banks can use bond buying to drive down a currency, since increasing the supply of dollars, pounds, yen or euros makes them less attractive to hold.

Eurozone banks are already awash with cash so analysts suspect they will fail to increase their lending no matter what the ECB does. Interest rates on eurozone sovereign debt are already low. That leaves only the exchange rate as a somewhat indirect means for generating the growth and inflation Draghi is looking for. Such are the deep-seated problems of the eurozone that even a €1tn bond buying programme unencumbered by German-imposed limitations is unlikely to do the trick on its own.

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