Quantitative easing alone will not do the trick
Very low inflation poses a mounting threat to the economic stability of the eurozone. The rate of consumer price inflation has been below 1 per cent since October, and hence far below the European Central Bank’s (ECB) target of just below 2 per cent. This highlights the degree of weakness in the eurozone economy – and reinforces it – notwithstanding the optimism generated by a return to modest growth. And it further increases doubts over debt sustainability across the currency union: without a healthy dose of inflation, it is much harder for households, firms and governments to reduce their debt burdens. To make things worse, in the most indebted countries, such as Greece, Portugal, Spain and Italy, inflation is even lower than the eurozone average. In response, many observers argue that the ECB should employ unconventional tools like quantitative easing (QE) to boost inflation. The problem is that QE alone is unlikely to be effective without a significant change in the ECB’s approach to monetary policy. The ECB needs to manage people’s expectations about the future path of demand, income and inflation more forcefully if it is to generate a proper economic recovery across the Eurozone.
According to one view of monetary policy, central banks set short-term interest rates to keep the economy close to full employment and inflation at the target level. In exceptional cases, this interest rate can fall to zero, but not below. In such circumstances, the central bank has to find other ways to stimulate the economy. One approach is QE: buying long-term assets like government bonds in order to drive up their price and bring down their ‘yield’, or interest rate (the price and yield of a bond are inversely related). Buying these bonds also tends to drive up the prices of other long-term assets like corporate bonds, equities and even property. QE thus lowers long-term interest rates, increases the value of firms and real estate, and drives up the wealth of households. Ideally, this induces firms and households to invest and consume more, and help the central bank reach its target on inflation.
A different view of monetary policy claims that interest rate setting or bond buying are just tools to keep firms’ and households’ expectations about the future path of income, demand and inflation on a reasonably stable and appropriately optimistic path. Such stable and optimistic expectations are a precondition for the investment and consumption decisions that keep an economy close to full employment, and inflation close to target. Of course, effective tools are necessary so that people believe that the central bank can steer the economy and, hence, so that the central bank can influence people’s expectations. But without properly managing economic expectations, the tools alone will be ineffective, according to this second view. Tools and expectations are thus complementary.
With these two approaches in mind, the ‘tools view’ and the ‘expectations view’, it is worth assessing the potential for QE to revive the eurozone economy, and hence, inflation. Starting with the tools view, there are several channels of transmission of QE.
* Lower long-term market interest rates could boost (larger) firms’ investment. But European firms raise finance predominantly from banks, not capital markets where the impact of QE would be directly felt. QE will therefore affect firms’ financing costs less than in the US, where capital markets are more important and where QE has effectively reduced long-term rates for firms. Given that banks are currently reluctant to lend in the most troubled southern European economies, the impact of QE on firms’ investment decisions in these countries is therefore likely to be low – just as in core countries like Germany where rates are already very low. If the ECB were able to buy bundles of bank loans to firms, QE would be more effective in lowering borrowing costs; but the current eurozone market for bundles of such loans is small.
* For households and investors, lower interest rates would make buying property more attractive. A rise in property prices usually stimulates the economy via construction and real estate services; the UK knows a thing or two about that. In the eurozone, however, a property-led boost to the economy is unlikely to be large. Spain and Ireland just came out of property bubbles and are healing only slowly; others, including core countries like the Netherlands, are struggling with falling prices whereas prices in France are already at very high levels and bound to fall. A slight boost in these countries means softening the hit, not driving a recovery. In Germany, the effect could be stronger but rising prices (and hence rents) would depress the consumption of the more than 50 per cent of Germans who rent. The effects of QE on the property market are therefore likely to be weaker in the eurozone than in the US or the UK.
* Property and other assets are also part of households’ wealth: QE would push up the prices of such assets, and households could thus consume more and save less (the so-called 'wealth effect'). However, the evidence on the size of this effect is mixed. According to an ECB paper, housing wealth does not seem to have much of an impact on consumption in the eurozone at all; financial wealth has a larger impact but it is still lower than in the US where households often own stocks and property for their pensions. Banks, as large owners of assets, are likely to benefit from QE. In current circumstances, where banks have insufficient capital and the ECB is likely to require many of them to raise more, higher asset prices help banks to repair their balance sheets and raise capital if need be. How much that would impact the overall economy is debatable: a pretty impressive recovery in asset values has already taken place without QE; banks’ ability to raise equity in markets is currently not in doubt; and banks’ lack of capital is only one of several reasons that prevent them from increasing lending to firms and households.
* By reducing long-term interest rates, QE would make the euro less attractive to investors, lowering its value, all else being equal. The fall in the value of the Japanese yen in the past 15 months, after the Bank of Japan’s (BoJ) aggressive QE programme, can attest to that. A lower euro would in turn support world demand for European exports, especially from southern Europe. Herein lies possibly the strongest channel through which QE can boost the eurozone economy directly.
* Finally, QE would help the treasuries of troubled countries such as Italy or Spain. By lowering the yield on their sovereign bonds – real yields are still high – QE would lower the cost of government borrowing. This lowers the pressure on governments to implement (mostly self-defeating) budget cuts in times of recession or weak growth, which would help the economy. It takes time for this effect to play out, however, as the costs of servicing existing debt are unaffected.
Overall, these direct channels are weaker in the eurozone than they are in the US or the UK. This is one reason to be sceptical about the likely impact of QE on the eurozone economy.
The second approach to thinking about monetary policy, the expectations view, induces further pessimism: firms' and households' expectations would be unlikely to change much for the better if the ECB simply implemented QE. And without such a change in expectations, the direct channels discussed above would do little to change firms' and households' behaviour.
The reason is that the ECB has failed to convince households and firms that it is doing all it can to lift the economy out of recession. It raised rates in mid-2011 at the height of the eurozone crisis when more stimulus would have been warranted and the bout of inflation was clearly temporary. Then it was slow to cut rates, even though the underlying price dynamic signalled clearly the future low inflation which has now shown up in headline figures. And the ECB has been reluctant to use unconventional tools at a time when high unemployment and a weak economy would have called for more aggressive measures than incremental cuts in interest rates – not least because inflationary dangers were non-existent. Starting QE now, after inflation has undershot the ECB's own forecasts repeatedly – essentially being dragged to the QE altar – is unlikely to convince anyone. The conservative approach of the ECB towards the economy and inflation, its hawkishness, is now firmly entrenched.
To make QE a success, the ECB needs to accompany it with the sort of strong commitments the BoJ in Japan or the Fed in the US have made: the BoJ said that it intends to continue a policy of QE and low rates until it has reached the new inflation target of 2 per cent (up from a de facto target of zero); the Fed has tied the duration of its unlimited QE programme to reaching certain targets on economic activity and unemployment. Both approaches led firms and households to change their expectations about the economy – about demand for their products or their income and future inflation – which in turn shaped their consumption and investment decisions.
A higher inflation target is, of course, out of the question for the ECB. With a mandate that is strictly focused on price stability and not much else (contrary to that of the Fed), it is also difficult for the ECB to tie QE to unemployment or economic growth – though reasonable people disagree on this.
However, the ECB does have the power to make a commitment that is purely focused on inflation (and hence firmly in line with its mandate). The ECB should announce that it aims to reach 2 per cent inflation on average over the next five years (an approach called ‘price-level targeting’). It might sound innocuous, but the word 'average' makes all the difference: since inflation is currently low and likely to remain low for a while, the ECB would commit to overshooting on inflation in the future. In other words, such a target would require the ECB to tolerate a mild boom in the eurozone to get the 3 per cent inflation necessary to reach a 2 per cent average over five years. Anticipating this, firms and consumers, financial markets and banks would increase consumption and investment.
If the ECB were to combine unlimited QE with a temporary price-level target – 2 per cent on average for five years – it could stimulate the economy and inflation, while remaining true to its mandate of price stability close to 2 per cent. Such a temporary price-level target would be new territory for the ECB, as would QE. But after years of misjudging the state of the economy and inflation, it is time for the ECB to be bold and innovative. The 19 million unemployed in the eurozone certainly deserve that the ECB makes every attempt at spurring a recovery worthy of the name.
Christian Odendahl is chief economist at the Centre for European Reform.