QE in the Euro area

Mario Draghi made it clear at  his press conference in early April that the ECB had no qualms about using QE if additional unconventional monetary policies were deemed necessary. The Bank may have come late to the party and asset purchases are not a given but the message has been reiterated over the past few weeks and that possibilty has been instrumental in driving peripheral bond yields in the euro area to levels few expected to see in a short time frame. The ECB is also more openly concerned about the euro’s relative strength  and its implications for the economic outlook  and some see QE as a means to weaken the currency, although the recent performance of the euro implies that not many in the foreign exchange market believe that QE is imminent or that it is negative -indeed traders have opened up speculative long positions in the currency.

In fact the  evidence on QE  elsewhere indicates that it can work through different channels and that it  may not precipitate a currency depreciation. Quantifying the impact of asset purchases is difficult as one can never know how the economy would have performed in its absence and expectations  can also  play an important role  but there are various statistical and econometric methods available which can at least give some approximations. The most recent work on the topic was published in a discussion paper by the Bank of England (‘What are the macroeconomic effects of asset purchases’, Weale and Wieladek, April 2014) comparing the effects of QE on the US and UK economies. The paper finds that QE does indeed have a significant impact on real activity and inflation, with asset purchases equivalent to 1% of GDP having a much bigger impact on real GDP in the US (a rise of 0.38%) than in the UK (0.18%) although a similar impact on inflation ( 0.38% in the US versus 0.3%)

The study also found that QE impacted the respective economies through different channels. The US is far less dependent on bank credit than the UK and longer term interest rates on financial instruments are much more important. Consequently, QE’s impact on longer term bond yields appears to have been the decisive channel in the US. In contrast,  the main impact  in the UK was through shorter term rates, which were  expected to remain lower for longer, and  reduced market volatility. The FX impact also differed; sterling’s real exchange rate was not seen to be affected by QE whereas the dollar did depreciate according to the study.

What are the implications for QE in the euro area?. Well, we know that the market for private sector bonds in Europe is not large so any purchases  by the ECB would probably concentrate on longer term government bonds (hence the rally of late) , although, again, shorter term rates and bank lending probably have a much bigger impact on the euro economy. That suggests that the impact on GDP would be nearer to the UK than the US experience and that  €1000bn in QE (around 10% of euro GDP) would boost GDP by some 1.8%. Inflation in the euro area is much stickier than the US or UK so one doubts if the CPI would rise by the  3% or more indicated by the BoE study. Nor is it  a given that the exchange rate would depreciate-indeed, by lowering the risk premium on peripheral bonds  QE may  actually support the euro.

Of course the ECB may decide to do nothing for a while longer, particularly given the prospect of stronger growth in the euro area in the first quarter, and in a sense the mere  promise of QE may have already achieved at least some of its aims. An actual announcement may  therefore  risk disappointment and lead to some selling of bonds  ( ‘buy the rumour. sell the fact’) . So if the ECB does want a weaker euro, negative interest rates might well prove a better bet  than QE given the mixed results elsewhere.

Irish Austerity Budgets: why more may be needed

The 2014 Irish Budget was the eighth in succession since 2008 (there were two  in 2009) which cut government spending or raised taxes with the total fiscal adjustment amounting to €30bn, including around €11bn in tax measures. These austerity Budgets were undertaken in order to reduce Ireland’s fiscal deficit and  therefore  comply with strictures under the EU excessive deficit procedure , with the State required to reduce the deficit to under 3% of GDP by  the end of 2015( last year’ it was 7.2%). The Troika may have gone but that requirement remains and Ireland, like others in the same predicament, has to produce a Stability Programme Update (SPU) each April, which sets out medium term forecasts for the economy, the fiscal outlook and the debt situation.

The latest SPU, just published, revealed that the  Government expects this year’s cash deficit to emerge €0.9bn below that initially forecast but that the General Government deficit ( the preferred EU budget measure) will still be about €8bn or 4.8% of forecast GDP, as per the original projection. Real growth in the economy is expected to be marginally stronger than envisaged last October , at 2.1%, although the Department of Finance is now much more upbeat about domestic spending, including a 2% rise in personal consumption and a 15% surge in investment spending, and now expects the external sector to have a negative impact on GDP, with export growth of only 2% offset by over 3% growth in imports.

The main change to the outlook relates to inflation, however, with price pressures across the economy now projected to be much weaker following the trend in 2013. Consequently nominal GDP  is now forecast follow a lower trajectory  in the medium term than previously thought; the 2014 forecast is for GDP of €168.4bn instead of the original €170.6bn , with similar shortfalls over the following few years That  change affects the debt dynamics and although the burden is still expected to fall from last year’s 123.7% of GDP the decline is now slower; the 2014 debt ratio is now forecast at 121.4% instead of the original 120%.

The growth forecast also envisages the economy gathering momentum into 2015 and beyond (although previous projections were too optimistic in that regard) and further strong gains in employment, a combination that might imply less need for further austerity measures. The Minister for Finance has signaled otherwise and to understand  why that may be  the case it is  necessary to delve a little deeper into the SPU document. The Irish economy, according to the EU, is actually operating very close to capacity and to full employment, a view which would surprise many and one that has met with some opposition, most recently from the ESRI in its latest ‘Quarterly Economic Commentary’. That debate may seem arcane but, unfortunately, it has serious implications for Irish households because on the EU view the Irish deficit is virtually all structural and therefore will not disappear with stronger growth. The actual deficit will shrink but if one adjusts for the economic cycle the structural deficit would still remain, requiring policy measures to reduce government spending and/or increase tax revenue. Moreover, Ireland is charged with reducing the structural deficit to zero  by 2019 from last year’s 6.2% of GDP, which implies the post-2015 fiscal landscape will not be as sunlit as some expect. A given economy’s position in the economic cycle is not observable and estimates are just that,so convincing the EU that far more of the  Irish deficit is cyclical would have a big impact on the perceived scale of  the fiscal adjustment required.

Irish household savings ratio continues it decline

The household savings ratio, the percentage of disposable income not spent on personal consumption, can be seen as a residual in the national accounts and in Ireland’s case is subject to sizeable revisions. Consequently it is not a robust  base for an economic projection yet many  forecasts are in part predicated on changes in the ratio and the widely held expectation that Irish consumer spending will pick up this year and next  explicitly or implicitly assumes a fall in the ratio i.e. that households will make a conscious decision to spend more from a given income. In fact, as the latest CSO figures reveal, the ratio has been falling steadily since 2009, and that against a backdrop of a declining trend in consumer spending.

The CSO figures refer to gross savings which are defined as that fraction of gross disposable income not spent, so it does not equate directly with a flow of money into savings products. The use of income to repay debt, for example, would class as saving on that definition, and we know from other sources that households have in fact been deleveraging for some time. The decision to save is also likely to be influenced by a host of other factors including interest rates, changes in the tax system, inflation and the state of the economy, with high and rising unemployment often seen as a catalyst for higher savings as households react to uncertainty. Similarly, an improvement in the economic climate and a decline in unemployment is viewed by forecasters as likely to precipitate a fall in the savings ratio and hence generate a rise in consumer spending above that indicated by the change in disposable income.

Gross savings fell in Ireland  at the peak of the boom, declining to under €6bn in 2007, but rose sharply over the following two years following the onset of the economic and financial crisis, exceeding €15bn by 2009. Savings in that year amounted to over 16% of disposable income (against a ratio of only 6% a few year earlier) but  the ratio declined steadily from there and fell back into single figures last year, at 9.4%.

The actual amount saved annually has also fallen steadily, to just over €8bn last year, but Irish households have also seen a significant decline in disposable income , which fell again marginally in 2013 to under €87bn from a peak of €102bn in 2008. Consumer spending has also fallen since the peak of the boom and the decline is therefore not driven by a rise in household saving- the weakness in consumption over recent years clearly reflects pressure on household incomes rather than any surge in precautionary savings. Indeed, the  fall in the savings ratio can be seen as households seeking to contain the fall in consumption by dipping in to savings.The savings ratio is still higher than it was prior to the crash, it must be said,  but is probably not the font for additional spending envisaged by many forecasters, including the IMF. The scale of data revisions also cautions against hanging any projection for an upturn in consumption on a change in the ratio.