Photographer: Martin Leissl/Bloomberg

Here’s a Rare Look Inside the ECB’s QE Gearbox

Transmission of policy works differently in Spain than it does in Germany

The European Central Bank is spending an unprecedented amount of money on euro-area debt in its efforts to revive the region’s economy and meet its inflation target. Eighty billion euros ($91 billion) of quantitative easing every month, to be exact. But is it working?

A new report by the Brussels-based research institute Bruegel gives a guarded ‘yes’ as an answer. One element of the analysis, by Maria Demertzis and Guntram Wolff, sheds a bit more light on the mysterious process known as “Portfolio Rebalancing.”

In theory, this mechanism should mean that the central bank's activity hoovering up relatively low-risk debt (government bonds) encourages banks, investment funds and others to swap those types of assets for riskier ones. By doing so, they funnel cash into parts of the economy otherwise starved of it, and help the central bank reach its objectives. It’s just hard to tell if that’s actually happening.

Bruegel, which counts the central banks of France, Italy and Luxembourg among its institutional members, uses its own data-set to show some interesting developments. In Spain, one of the countries worst hit by the crisis, local banks are happy to sell their sovereign bonds to the ECB. Holdings declined by more than 6 percentage points in the year to the end of 2015.

“We can see that resident banks are selling, and that’s good because it means they are getting cash in, and it also helps break down the link between the sovereign and the banking system,” Demertzis said by phone.

In Germany and France, however, that effect is much less pronounced, suggesting that banks there don’t need the ECB cash as much. It could also mean that in Germany there’s been a relative shortage of appropriate bonds available on the market.

While that in some ways is a feature of QE’s design, it also means that this conduit of ECB policy needs to be monitored, according to Demertzis. 

Having been extended and expanded to include corporate bonds in March, the ECB has shown that it’s willing to stretch its existing instruments in pursuit of its 2 percent inflation target. More than a year in, however, prices aren’t budging much — euro area annual CPI was at minus 0.1 percent in May.

“Markets still have faith that the ECB is able to manage inflation, given enough time,” Demertzis and Wolff write. “However, this confidence is beginning to wane given the scale and unconventional nature of the measures taken and the absence of inflation. It is unlikely that confidence will be sustained for long in the absence of a visible increase in aggregate demand and inflation.”

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