QE shows ECB is serious about threat of deflation

The extension of the European Central Bank’s (ECB) asset purchase programme in January has led many to consider that as the beginning of a quantitative easing era in Europe. But the defining moment, in our view, was the September meeting, when the ECB set for the first time a target for the size of its balance sheet. Since then, the ECB has effectively “gone quantitative”.

Still, the January announcement is important because it shows the ECB takes the deflation threat seriously: the commitment to buy €60bn worth of assets every month is open-ended, until downside risks to prices return to acceptable levels.

The impact of this decision on the euro-area economy is uncertain, as is the effectiveness of unconventional policies generally. Studies on the US and UK experiences over recent years differ in their conclusions. What we learn from them is balance sheet policies have a positive effect on growth and inflation, but their impact is uncertain, varying and probably small overall.

The QE programme should affect the economy through several channels. The first is ‘signalling.’ By responding aggressively to deflation risks, the ECB asserts its credibility regarding inflation objectives and pushes the prospects of normalising policy further out into the future. This should both lift long-term inflation expectations and reduce real rates.

In terms of bank lending, lower interest rates for end-clients and lower funding costs for banks stimulate demand for credit and money creation, a necessary condition for inflation.

Depressing returns on safe assets encourage investors to take additional risk and finance the real economy. This lifts the price of risky assets, improving confidence, and strengthening the financial position of the private sector, balance sheets and collateral, leading to portfolio rebalancing. Higher asset prices, both for financial and real assets, such as housing, boost the net wealth of households and support consumption spending.

A major implication of balance sheet policies is also currency depreciation, allowing the euro area to import inflation from its trading partners. The European Commission recently estimated a 5 per cent depreciation of the euro in trade-weighted terms adds 0.3 per cent to inflation over a year. Since September 2014, the euro has depreciated 7 per cent and we think this trend has further to run.

How these different channels will work in practice is not straight-forward to assess. They certainly have different time horizons and some are more easily observable than others. In the short run, dominant drivers are likely to be the currency and portfolio rebalancing. As mentioned, the euro is falling, not only against the US dollar but also the British pound and Swiss franc. The impact on CPI inflation is for now offset by the correction in oil prices, but as the latter stabilise, the currency effect should be felt more clearly. Portfolio rebalancing is evident in the tightening of peripheral sovereign spreads, credit spreads and outperformance of European equities.

In the medium term, two other channels appear critical. First, one important way the ECB will assess the effectiveness of its programme is through long-term inflation expectations: ‘five-year/five-year’ inflation swaps are their preferred gauge, which so far has failed to recover ground lost since June 2014. Secondly, bank lending needs to show signs of recovery, so that money creation can come back to a level consistent with 2 per cent inflation.

An ECB “rendez-vous” in September 2016 will give markets the bank’s first conclusions. Despite the positive effects described above, we are sceptical deflation risks will have diminished enough by then to justify an end to the programme. Rather, we except the ECB’s QE to extend well into 2017.

Maxime Alimi, Senior Economist, AXA Investment Managers