The European Central Bank (ECB) provided a welcome boost to European markets by announcing a larger-than-expected €1.1 trillion (£824 billion) asset purchase programme on Thursday, but questions have been raised over why it waited so long to launch it. Here’s one of the best theories we’ve found for why.
The eurozone’s inflation rate has been falling since late 2011 and has been below 1% since October 2013. That is substantially short of the ECB’s target of “below, but close to, 2%”. Despite this the central bank appeared comfortable watching it fall still further until it finally fell dropped to -0.2% in December (that is, prices across the region were falling).
So why did the ECB wait until Europe was flirting with deflation before taking action?
“I spent most of 2014 telling people that there was no chance of ECB QE until early in 2015. My reasoning was that a big intervention program could only have any chance of working if the banking system was able to support it by expanding credit, and that Mario Draghi knew that there was no point in pouring central bank funds into the leaky bucket of the Euroland banking system until the Asset Quality Review was finished. That happened late in October, and nothing happens in November or December, so January was the first possible month. This wasn’t any particular piece of predictive genius on my part, by the way — it was always the plan and he said so, in so many words, in a number of interviews and speeches. The year of 2014 had always been written off by the ECB as far as policy went, as a year in which the underlying problems in the banks had to be dealt with before there was any point starting anything else.”
The Asset Quality Review (AQR) was effectively a health check of the European banking system. It was intended to be much more rigorous than previous stress tests in order to provide investors with reassurance over the health of the region’s banks and force those with weak balance sheets to raise additional capital.
In the event 25
of Europe’s biggest banks failed the eurozone’s health check, out of 130 in total. These banks were found to be short a total of €25 billion ($US31.67 billion), and the overall impact on them runs to €62 billion ($US78.55 billion). Of these, 12 had already raised the required capital to cover their shortfall, but the rest were required to raise another €9.5 billion ($US12.94 billion).
With all of that hanging over them, it seemed unlikely that measures aimed at increasing bank lending to higher risk companies would have been likely to succeed. And, moreover, this theory appears to have been backed up in the data.
According to the ECB’s Bank Lending Survey, the fourth quarter of last year saw bank lending in the eurozone beat expectations for the first time in two years.
Encouragingly, the authors noted that “financing needs related to fixed investment in particular…contributed to the increase in net loan demand by euro area enterprises, recording the first significantly positive contribution since mid-2011”. That is, companies (particularly in Germany and Spain, two of the region’s largest economies) are finally starting to borrow to invest rather than merely restocking inventories suggesting they expect better demand for goods and services in future.
And the good news didn’t stop there. Lending to fund house purchases beat expectations for the third consecutive quarter. In the last three months of 2014 demand for housing loans rose 24%, markedly above its historical average, driven predominately by perceived housing market prospects:
All of which is to say, unlike the US and UK versions, the ECB is launching its QE programme into a credit expansion cycle. Given that the unemployment rate across the eurozone was 11.5% in November, and over 20% in Spain and Greece, the central bank could do worse than fanning the embers of a credit boom to raise demand in the region and close its gaping output gap (the amount of unused potential in an economy).
There are a couple of words of warning about this rosy picture, however.
The first is that the ECB has a proven unwilling to allow even a modest inflation overshoot (above 2%) in the past. That suggests that if inflation does start creeping up it is highly possible that it will raise rates well before it hits its target. This despite the fact that a sustained period of slow growth with low inflation as the eurozone has experienced could, in theory, justify a period of above-average growth consistent with a slightly higher level of inflation in order to take up the slack.
It’s important to remember that if QE predominantly boosts lending in stronger core economies, and fails to improve credit conditions in the struggling periphery then these countries would have to be willing to accept rising domestic demand and consequent higher inflation in order to pull the rate of price rises across the region back towards target. It remains very unclear that they would accept such a deal and they could put pressure on the ECB to wind back its efforts.
Secondly, the idea that QE leads to an increase in bank lending, as Davies indicates above, is still somewhat controversial. A Bank of England paper from last year found “no statistically significant evidence from either approach that those banks who received increased deposits from QE lent more, all else equal”.
However, one possible reason for this is that both the UK and US versions of QE were undertaken during a period of distress in financial markets with banks attempting to rid themselves of bad assets and shrink their balance sheets. If Europe is indeed moving into the early stages of a credit expansion cycle, it is possible that monetary policy easing will have a greater effect in this area — especially since European firms relying much more heavily on bank financing than their American peers.
At any rate, it seems we do have a good theory why the ECB waited until now to launch it asset purchase programme. But we still don’t have a very clear understanding of exactly how it’s supposed to work.