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.