Ever since inflation in the euro zone fell to less than 1 per cent more than a year ago, the European Central Bank has toyed with the idea of launching quantitative easing – boosting the money supply to ramp up inflation. But ECB president Mario Draghi never had the nerve to hit the QE button even as inflation tumbled.
Maybe he was waiting for a miraculous economic turnaround that would send armies of consumers galloping to the shopping malls. Maybe he was getting roughed up by the German central bank, the Bundesbank, which, we know, thinks QE is somewhere between useless and dangerous.
The tedious waiting game is over. It is almost entirely certain that QE, through the mass buying of government and corporate bonds, will be introduced, if not actually launched, on Thursday. None of the endless leaks to the media about the broad QE plan has been denied by the ECB, and the recent manoeuvres of the national banks of Switzerland and Denmark suggest QE is indeed imminent. As traders sold the euro in anticipation of QE, the former abandoned the franc-euro peg, sending the franc soaring, and the latter pushed its deposit rate further into negative territory.
The only question is: Will the European version of QE be effective?
QE is a tricky beast to analyze and entire forests have been shredded to print economists' papers on the topic. The short answer is that, in the United States, Britain and Japan, it probably did work to some degree, but not without a little help from its friends.
QE alone didn't pump up the American economy, which is expected to grow by 3.6 per cent this year, according to the International Monetary Fund forecast. Plummeting energy prices, the bailouts of the auto makers and the huge bank cleanup effort no doubt helped. To be sure, so did the sheer size and predictability of the American QE program. The hat-trick of QE programs saw the U.S. Federal Reserve Board buy about $3.5-trillion (U.S.) of Treasuries, mortgage-backed securities and the debt of government-sponsored mortgage agencies. The IMF says American QE did inflate asset values, including equities, adding to the wealth effect.
Mr. Draghi should be so lucky with his own QE effort, but chances are the European version will carry less bang for the buck (or euro) than the American edition. The German factor cannot be minimized. Resistance to QE from the Bundesbank and the German members of the ECB's governing council will probably ensure that Mr. Draghi will come out swinging with one arm tied behind his back.
A report in the German daily Frankfurter Allgemeine Zeitung said that the ECB's own internal economic models had concluded that a €1-trillion ($1.4-trillion) asset-purchase program spread over a year would add between 0.2 and 0.8 percentage points to consumer prices.
But few economists expect QE of that size, more likely half that – QE lite – because of German reluctance to support a full assault on deflation that may not work. So assume that the ECB's QE program lifts inflation by 0.4 of a percentage point next year – half of the best-case scenario. Royal Bank of Canada's investment arm in London had forecast that euro zone inflation (which turned negative in December, year on year) will rise to only 1 per cent at the end of 2016. Add the theoretical 0.4 of a percentage point derived from QE and you get a figure – 1.4 per cent – that is still well below the ECB's target inflation rate of close to 2 per cent. Of course, the inflation figure could be a lot less if oil prices remain low and QE becomes a dud, which it could.
RBC notes that QE can work well during a crisis when investors and consumers are desperate for a signal from central banks that rescue missions are coming. The Fed launched its first QE program in November, 2008, two months after the collapse of Lehman Brothers, when investors were convinced the world was going to end. "But in the current [euro zone] situation, where we are not in 'full-blown' crisis mode, but merely seeking to engineer a higher growth and inflation trajectory, then QE is less powerful – it doesn't have the same transformative impact on sentiment," an RBC team led by chief European correspondent James Ashley said in a Jan. 15 note.
The differences between the U.S. and the European markets are bound to make the ECB's job more difficult. In the United States, fewer than half of corporations get their funding primarily from banks. In Europe, the figure is more than 80 per cent. QE in Europe will not fix undercapitalized banks and, as long as they are unwell, they won't pump up the credit supply and get the economy moving. The wealth effect from QE in Europe is bound to be muted, simply because European households are far less invested in financial assets than American ones.
Serious economic structural reform might be the best solution to the deflation and growth problems, a point not lost on Mr. Draghi, who has used every ECB press conference to urge governments to keep reform efforts alive. It's also possible that falling oil prices, while deflationary, will do more to boost the economy than QE because cheap oil effectively translates into a tax cut for all.
So why is Mr. Draghi pursing QE? Maybe it's because he has to be seen as a man of action as inflation turns negative, or because he hopes that QE will keep pushing down the euro, giving exporters an advantage. The euro has fallen 15 per cent against the dollar in the past year, partly in anticipation of QE. Whether it will keep falling after Thursday is an open question. For Mr. Draghi, QE is an enormous gamble.