Monetary challenges in Europe
- The results of unprecedented monetary easing measures in the past several years have been relatively disappointing so far
- To some extent, we believe, this is due to counterproductive effects
- The strong monetary expansion also carries risks, such as excessive valuations in financial instruments or a deterioration in the functioning of markets
- Although we believe that ‘muddling through’ is the most likely scenario in the years ahead, more radical scenario’s (such as a complete failure of policy) are entirely possible
Since the outbreak of the global financial crisis in 2008, the ECB has rolled out an unprecedented series of monetary easing measures. These primarily revolve around a negative deposit rate, long-term loans to the banking system and a comprehensive bond purchase programme. Since 16 March, the ECB’s deposit rate has stood at -0.4%. From June 2016 onwards, new long-term targeted refinancing operations will allow banks to fund themselves at rates as low as this deposit rate, so long as they provide sufficient new (business) loans. Furthermore, as of April the purchase programme has been expanded from EUR 60 billion to EUR 80 billion per month. From the second half of 2016 onwards this programme will also include (investment grade) non-bank private sector debt.
How did we get here, and why?
The main reason for this monetary easing is the slow economic recovery and the fact that inflation has now been running below the ECB’s target level for several consecutive years. While lower commodity prices are partly to blame, core inflation and inflation expectations are also too low for comfort (Figure 3). The idea behind the easing measures is that low interest rates stimulate consumption and investment. Meanwhile, the purchase programmes lead - through the portfolio balance effect - to higher prices of financial assets. The resulting increase in household wealth should further spur consumption and growth. The expansionary effect of the purchase programme, through increased money supply, raises inflation expectations (according to Fisher’s classical equation of exchange). Moreover, in recent years weakening the euro seems to have become an important secondary objective. This should encourage both exports and imported inflation. At least, that’s the theory.
The currency war makes things worse...
Reality is more stubborn. In its strive for a weaker currency, the ECB has increasingly become part of a global ‘currency war’ between major central banks. 'Beggar-thy-neighbour' policies provoke counterattacks from other central banks. Furthermore, while a weaker currency may temporarily benefit exports, in a world where businesses increasingly operate in cross-border supply chains, a simultaneous rise in import prices could partly offset the rise in export demand. And as corporations are increasingly funding themselves with foreign currency debt, this further offsets the currency impact. In short, the pursuit of a weaker euro has all kinds of side effects. This is particularly true for the instruments used by the ECB.
Confidence in monetary policy is under pressure
To weaken the euro, the ECB has cut rates more aggressively than its peers. That policy interest rates can indeed be negative for a major central bank has now been proven (Figure 2), but where the lower boundary is remains hard to determine. As regards the financial markets, this boundary may have been reached already as market participants appear to have lost faith in central banks’ policies. This is reflected by increasingly unpredictable and perverse market reactions in response to policy actions, such as the sharp appreciation of the yen since the announcement of negative rates in Japan last January. As for the ECB, since the announcement of the bond purchase programme in January 2015 the 5y/5y inflation swap has decreased from around 1.6% to 1.4%. That said, our calculations [for more detail on the methodology, see "How real is the rise in inflation swaps", Financial Markets Research] suggest that this decline would have been 20 bp more in the absence of QE (Figure 4). However, we would argue that a QE programme worth EUR 1600 billion is quite a high price to pay for a mere 20 bp gain in inflation expectations.
Why has the effectiveness of policy measures declined?
The answer to this question can be divided into a number of aspects.
1. Expansionary policy by the ECB does not solve the real problems
The premise of the ECB's measures is to strengthen the demand for goods and services, by stimulating lending. Growth problems in the eurozone, however, go much deeper (see also: "Why growth keeps disappointing" by Erken, De Groot and Koopman) and are driven by structural shifts in the economy and a lack of innovation and productivity growth. In the past, aggregate demand growth has been realised through credit expansion, but perhaps we have reached the limits of this model.
2. A dysfunctional monetary transmission mechanism
Although market-based financing of Eurozone corporates has been on the rise (boosted by the purchase programmes of the ECB), the banking system remains an important source of funding to the private sector (Figure 5). Since the crisis, banks are subject to increasingly tighter regulatory capital, liquidity and leverage requirements. Raising capital is proving a much more difficult task for banks than raising funding. The limited enthusiasm among banks for the ECB’s TLTRO programme introduced in 2014 stands to support this claim. At the same time, a lack of demand for credit is also a reflection of the fact that the private sector sees few growth opportunities, which again points at structural problems.
3. Distorting effects of low interest rates and purchase programmes
The fact that ultra-low market interest rates have a negative impact on the coverage ratios of pension funds is no secret. This is because pension funds have to discount their liabilities against long-term market rates. Uncertainty about the final values of pension savings and, indeed, uncertainty more generally, may encourage households to save more. Households may also feel the need to save more because it takes more time (or a higher initial outlay) in order to reach a certain (nominal) target wealth. In any case, ever since money market rates have fallen to near-zero, the aggregate household savings rate has increased rather than decreased.
In addition, it is noteworthy that the ratio of corporate investment to GDP in the Eurozone has barely increased in recent years, despite the fact that interest rates have fallen significantly. Another striking phenomenon of recent years is that the vast majority of jobs created have ended up in the 'soft sector' (food and beverage services, residential care, retail) rather than in the 'hard sector’ (production of high technology, engineering, programming, consulting). This could be the result of a change in investment policy. But there also appear to be counter-productive effects from ultra-low interest rates:
- Low interest rates in the market may lead companies to invest in projects with a low return, resulting in decreased innovation and productivity growth
- The ECB’s purchase programmes distort the allocation of capital: low interest rates keep uneconomic business models intact. And, if it is so easy to make money in the financial markets, why would one invest in the real economy? Primary equity issuance has been slow in recent years, in contrast to market-based debt issuance.
What are the risks?
Besides the fact that the ECB measures are becoming less effective, we see growing risks stemming from its policy initiatives. Future (hyper-) inflation is often referred to in the popular press, but as long as the liquidity created by the ECB only slowly seeps into the economic system, the risk of a sudden rise in inflation remains limited. In our view, three types of risk are the most relevant.
1. Credit risks to the Eurosystem
These mainly relate to the provision of liquidity to banks and the purchase of debt securities (under the PSPP). At first glance, these risks are limited because i) the Eurosystem boasts an ample amount of capital/reserves and revaluation accounts (EUR 97 billion and EUR 346 billion respectively in 2015); ii) the central bank can never really become insolvent because it can simply print more money in the worst case; iii) the provision of liquidity (which has already declined sharply since 2012, see Figure 8) is secured by collateral.
As for the PSPP, the ECB has agreed to put the bulk of the risk associated with the purchase of domestic debt on the shoulders of the national central banks (see also: "What's the risk of limited risk sharing?", Financial Markets Research, 27 February 2015). However, whether this system can withstand a systemic crisis and/or the withdrawal of one or more countries from the Eurosystem - possibly inspired by a Brexit - is uncertain. Furthermore, central banks in core countries still have very large potential claims on central banks in the periphery (Target-2 balances, see figure 9). But it is virtually impossible to quantify the impact and cost for the system as a whole.
As an aside, the system of central banks is already well on the way to taking very substantial amounts of government securities onto its balance sheet, thereby eventually becoming part of the problem itself and giving it an incentive to prevent any debt crisis. In practice, that could translate into the ECB increasingly nibbling at the boundaries of its purchase programme and keeping interest rates low(er) for longer.
2. Risks to market liquidity
As the Eurosystem buys an increasing portion of total debt in a market where new supply is already limited and some investors are required to hold this debt for regulatory purposes, the free float volume of the paper tends to decrease. This could affect price volatility, risk premiums, bid-ask spreads, etc. (see also: "Looking at market liquidity - the theory", Rabo Rate Directions, 5 Feb 2016). The sharp movements in the bond markets in the spring of 2015, where the yield on 10-year German paper slumped to just 0.07% in April and rise subsequently to nearly 1% in only six weeks’ time, were possibly aggravated by tighter liquidity in the market as a result of the purchase programme.
3. Financial stability and bubbles
It is our opinion that the central bank's policy is inflating the valuations of financial assets. Risk premiums in some markets have fallen to levels not far from those seen just before the credit crisis in 2007/08. The price-earnings ratio of the Euro Stoxx 50 index has almost doubled since 2010 from around 11 to 22. The yield on 10-year German government bonds is still a very meagre 0.15%. These higher valuations of financial assets carry the inherent risk of a serious price adjustment. To some extent this scenario appeared to unfold in the first six weeks of 2016, although that market correction was nipped in the bud by fresh easing measures from the central banks (which only strengthens our point!). The same applies to non-financial assets such as property, to the extent that prices are pushed up by lower interest rates.
How far the ECB could still go? What are the next steps?
As long as European policymakers do not make further structural reforms, supported by a more accommodative fiscal policy, the ECB will feel compelled – seeing its inflation mandate – to continue to run a very expansionary policy. As President Draghi noted in his January 2016 press conference: "We never give up." Looking forward to the next two years, we distinguish three scenarios.
Scenario 1: Muddling through (most likely)
The ECB’s policy works only sparsely as the negative effects of the policy increasingly offset its benefits. With ups and downs, growth remains meagre. And although inflation no longer declines, it does not move decisively towards the ECB’s objective of ‘close but below 2%’ either.
In this scenario, we can expect the ECB to continue on its chosen path. Although we do not rule out a decline of a few more notches in the deposit rate, an extension and expansion (in terms of its projected end date and purchase amounts) of the purchase programme is the most obvious choice. However, after the addition of SSAs, regional government securities and corporate bonds, any further expansion can actually only be achieved by adjusting the parameters of the purchase programme (for a detailed discussion see: "Let's talk options (ECB Preview)" Financial Markets Research, 4 March 2016). There are a lot of political snags to such a decision, and the risk of an internal clash in the ECB Governing Council is therefore likely to grow in this scenario.
Scenario 2: The policy is counterproductive (less likely but certainly not unlikely)
As a result of counterproductive measures, the currency war intensifies as a growing number of central banks wade into negative rate territory. Economic growth declines and so does inflation. Long-term inflation expectations fall, eventually reaching Japanese levels. Radical options are no longer taboo.
Ultimately, the central bank might even resort to ‘helicopter money’. Actually, this comes close to monetary financing, with the proviso that it is not accompanied by an increase in government debt. The key question in this scenario will then be: does a radical policy lead to a sudden and very sharp spending impulse and higher inflation, or do households once again decide to repay debts and save the money that has been created?
Scenario 3: The policy gains traction (most hopeful, but least likely)
In this scenario (call it ‘hope springs eternal’), the ECB’s policy actions finally start to bear fruit. In the US, unemployment has fallen to 4.9% and we see the first signs of an acceleration in underlying inflation. That could also happen in the Eurozone. If unemployment keeps falling at the same pace it has since 2013, it would reach the NAIRU level by mid-2017. Once there is a sufficiently strong recovery in the output gap at global level, there would be no need for weaker exchange rates and the currency war would subside. Although the economic situation in China and overcapacity in some emerging market countries remains a source of uncertainty in this scenario, the ECB will likely have to start thinking about an exit strategy. It may draw upon the recent experience at the Fed, which started tapering its purchases in January 2014.