The Quantitative Easing Experiment Is Failing
Friday's eurozone inflation figures are expected to show that consumer prices were unchanged in October. Inflation hasn't been at the European Central Bank's 2 percent target since the start of 2013; it's been half that or less for the past two years. So I sympathize when ECB President Mario Draghi says he'll expand the use of non-conventional measures to avert the threat of deflation; but I worry that with no evidence that the patient is responding to treatment, increasing the dosage is pointless.
The consensus among economists is that inflation won't return to the central bank's target this year, next year or even the year after. As Bloomberg Intelligence economist Maxime Sbaihi points out, the downward drift in the ECB's own survey of market expectations is pretty relentless:
ECB member Peter Praet told AFP this week that there won't be any "taboos" restricting efforts to avoid deflation:
We’re in a situation in which the reaching of our inflation objective could be delayed. We haven’t denied that this is a real risk.
As Draghi himself noted last week, "the credibility of a central bank is measured by its ability to comply with its mandate." So the bank is under enormous pressure to do something. The big question, though, is why anyone should expect more of the same to produce different results.
Expanding quantitative easing isn't straightforward. Trying to accelerate bond-buying from its current pace of 60 billion euros ($67 billion) a month risks running out of securities. The ECB isn't allowed to buy anything yielding less than its deposit rate, currently at -0.2 percent. So a chunk of the German market is ruled out; four-year German government debt, for example, yields about minus 0.26 percent, with shorter-dated securities also off limits since they offer even lower returns. Lukanyo Mnyanda at Bloomberg News calculates that the bond-market rally following last week's ECB meeting drove yields on an additional $190 billion of government debt below zero, leaving $1.57 trillion of the euro zone debt market with negative yields.
Cutting the deposit rate even further below zero, which Draghi said was discussed last week, should widen the net of permitted securities. But it also drives government bond yields even lower -- last week's hint about a cut helped drive the two-year German note down to -0.35 percent today, a 10 basis-point drop in a week. Last week, two-year French notes became ineligible for QE at record-low yields of 0.29 percent.
Draghi spent a fair amount of time at Thursday's press conference explaining why the bank's previous reluctance to drop official interest rates much below zero -- the so-called zero bound -- has dissipated:
How come that we announced a year ago that that was practically the zero lower bound, and now we are thinking of going into further negative territory? Given the conditions prevailing a year ago, that was a statement. Today, things have changed.
So the economic situation has deteriorated since the ECB belatedly embarked upon QE, reinforcing the impression that the central bank is basically making up policy as it goes along. That's quite an indictment of the shortcomings of QE. With the average annual change in euro region consumer prices at minus 0.1 percent so far this year, Draghi has been forced to bow to reality. Pretending that 2 percent can be reached when his preferred measure of market expectations -- the five-year rate on five-year forward inflation swaps -- has been below that target all year isn't helpful.
One policy that on its face is working a bit better than QE is the ECB's campaign to support exports by keeping a lid on euro strength. Bloomberg strategist Vassilis Karamanis has noticed an oddly compelling tendency for various ECB members, including Benoit Coeure, Vitor Constancio and Ewald Nowotny to pop up with market-moving statements whenever the single currency threatens to breach $1.14:
This risks encouraging a beggar-thy-neighbor strategy in every country that sees cheapening its currency as a route to export growth. Wednesday's move by Sweden's Riksbank to expand its QE program, for example, is a direct retaliation to the ECB's hints that it will introduce more unconventional policy measures by the end of the year. (The benchmark Swedish interest rate is already down to minus 0.35 percent)
So what might the ECB deliver in December to make an impact? A deposit rate cut seems a certainty -- Draghi suggested some policy makers wanted to move as early as next week. The ECB can announce that the program will run past its mooted end-date of September 2016, which in turn would enable it to add more than 1.1 trillion euros to its balance sheet.
The QE program could also be expanded to include corporate debt or even equities. While that's politically tricky (how does the ECB decide which companies from which countries to invest in?), it would erase doubts about the size of the securities universe available to the program.
I'm increasingly skeptical that QE can do what the textbooks say it should to channel money into the economy via the banking system. But Draghi has promoted himself as the guy who will do whatever it takes to safeguard the euro and meet the ECB's targets. Having belatedly embraced QE as the cure, Draghi is close to the point when he'll need a crash cart to stop the economy from giving up the ghost.
The good news is that an extended period of slowflation or noflation (take your pick) hasn't proved the disaster for retail spending that economic theory predicts -- at least so far. The bad news is that sticking to targets that never get met makes it hard to maintain any faith in the world's central banks and their stewardship of the global economy -- and that goes for the ECB, the Federal Reserve, the Bank of Japan and the Bank of England.
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