Draghi’s QE History Lesson Is That Flexibility Can Backfireby
Stock versus flow argument for QE may shape exit strategy
ECB holds two-day policy meeting in Frankfurt this week
As the European Central Bank moves closer to picking a route out of quantitative easing, it might have to clarify its philosophy on how the program works.
The ECB’s commitment to buy 80 billion euros ($88 billion) a month of debt until March 2017 will add 1.7 trillion euros to its balance sheet compared with the start of the plan two years previously. Yet the central bank has also pledged to keep going if needed to revive inflation, raising the question of whether it’s relying on the flow of purchases or the stock of securities to deliver its punch.
The answer matters if policy makers are to avoid undermining their own stimulus when they choose to end it, as history has shown that investors are acutely sensitive to the slightest signals on the pace of asset purchases. With open-ended programs prone to speculation about their intended final size, and so risking a backlash in financial markets that damages the economy, communication will be key as the ECB transitions from adding monetary accommodation to merely preserving it.
“If you follow the stock hypothesis, you shouldn’t have any significant effect from when purchases are stopped or tapered because the stock would remain intact due to reinvestment,” said Francesco Papadia, the ECB’s director general of market operations from 1998 to 2012, adding that officials may step up their message on the importance of the stock as the program comes to an end. “If it’s the flow, when the flow is not there anymore, you should have a bouncing back of yields.”
Under the flow argument, prices in financial markets react to the continued stream of stimulus. The shock of ending purchases can be mitigated by reducing them gradually. Under the stock theory, purchases stop abruptly once the target is reached. In both cases, maturing debt can be rolled over to ensure monetary conditions don’t tighten too quickly.
The Governing Council has so far kept the topic of ending QE off its agendas, even though some officials have expressed a preference for phasing out purchases slowly. They have an opportunity to discuss the issue this week during a two-day policy meeting in Frankfurt. If they wish, they can draw on experiences at the U.S. Federal Reserve and the Bank of England.
Under the Fed’s third and final asset-purchase plan, monthly bond-buying started at $40 billion from September 2012 and was raised to $85 billion in December. Bringing it to an end got off to a rocky start -- when then-Chairman Ben S. Bernanke told lawmakers in May 2013 that purchases might soon be tapered, financial markets went into a spin. The program was eventually wound down relatively smoothly from early 2014 to October that year.
In contrast, the BOE focuses on the overall size of its asset-purchase facility and went through several phases of ending and restarting buying without any investor backlash. It bought a total of 200 billion pounds ($244 billion) of gilts from March 2009 to January 2010, then paused before resuming purchases in late 2011, raising its holding to 375 billion pounds over a year. Officials increased the facility to 435 billion pounds after Britain’s vote to leave the European Union.
Given those experiences, it’s “highly unlikely” that the ECB subscribes to the view that the flow of purchases is important, according to Tony Yates, a former BOE official who advised policy makers on monetary strategy when they designed the central bank’s asset-purchase plan.
“The preponderance of the evidence is that the effect of QE comes from the stock,” said Yates, now an economics professor at Birmingham University in England. “If you take that evidence, there’s really not much justification for tapering.”
If that’s so, ECB President Mario Draghi may need to make it clearer. At the moment, he appears to be trying to have it both ways.
Officials seemed to favor the stock argument when they turned their attention to balance-sheet stimulus two years ago. In the months before QE was announced, Draghi said he wanted to add about 1 trillion euros to the institution’s balance sheet, taking it to 3.1 trillion euros.
Since then, policy makers seem to have switched their mindset to favor flow. After initially agreeing to buy 60 billion euros a month of debt through September 2016, officials expanded purchases to 80 billion euros a month, extended the program by six months, and committed to reinvest the principle on maturing debt.
The original balance-sheet target was passed in June. Total assets now stand at almost 3.5 trillion euros, and an end to purchases is not in sight, with the program set to run “until the Governing Council sees a sustained adjustment in the path of inflation consistent with its inflation aim.”
Since the ECB is still far short of its goal for consumer-price growth of just under 2 percent -- the rate was 0.4 percent last month -- that inevitably puts the investor focus on flow.
“Regardless of the total balance-sheet expansion, that’s the real information the market is looking at,” said Marco Valli, chief euro-area economist at UniCredit SpA in Milan. “The key information is the monthly flow and tapering makes absolute sense, even though now is not the time.”