Euro Area – Q&A on QE

IMF Blog, July 14, 2014

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Euro Area – Q&A on QE

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Bibliographic details

• Authors: Reza Moghadam, Ranjit Teja
• Published: July 14, 2014

Overview

• Context: As inflation has sunk in the euro area, discussion about quantitative easing (QE) and misgivings about it have risen. The IMF’s latest report on the euro area states that “… if inflation remains too low, the ECB should consider a substantial balance sheet expansion, including through asset purchases.”
• Purpose of Q&A: Explain what QE is, how it differs from past ECB balance sheet measures, what assets might be purchased, how QE would work, its likely effectiveness in a bank-based system, reasons the ECB has stopped short of QE to date, and potential side effects.

What QE is and how it differs from earlier ECB measures

• Definition: QE is a sustained expansion of a central bank’s balance sheet through outright purchases of longer-term assets, sustained until inflation goals are met.
• Differences from LTRO-type expansions:
  • LTROs (3-year Long Term Refinancing Operations launched in 2012) expanded reserve money by offering funding to banks against eligible collateral.
  • QE would: (1) make outright purchases of longer-term assets (longer than 3 years); (2) expand the balance sheet at the ECB’s discretion (not that of banks or others); (3) sustain purchases until inflation objectives are achieved.
• Outcome of LTROs: Eased concerns about stable funding and liquidity, but pre-payment of LTROs by banks undid much of the initial reserve money expansion; LTROs prevented worse outcomes but did not lift private credit and broad money.

Asset choice for QE

• Viable asset classes:
  • Securitized private assets: markets are too small (mortgages, loans to SMEs) to sustain QE currently.
  • Corporate bonds: market too small.
  • Bank bonds: plentiful and liquid but concentrated.
  • Equities: central banks rarely buy equities.
  • Sovereign bonds: the only viable option presently.
• Recommended approach:
  • ECB purchases should be across the board (not just core or periphery) because low inflation is an across-the-board problem.
  • Neutral, mandate-driven purchases (e.g., according to countries’ share in ECB capital) can rebut claims of “monetary financing of fiscal deficits.”
• Policy note: QE can give impetus to develop markets for securitized assets.

How QE would work—channels and effects

• Signaling and expectations:
  • QE raises growth and inflation expectations by signaling ECB resolve to achieve its inflation objective.
  • The ECB’s Outright Monetary Transaction announcement demonstrated the potency of “whatever-it-takes” signaling.
• Real interest rates and asset prices:
  • QE reduces nominal interest rates and raises inflation expectations, lowering real interest rates and lifting demand and asset prices.
• Portfolio rebalancing and valuation effects:
  • Sovereign bond purchases raise sovereign bond prices directly.
  • Sellers (banks, pension funds, asset managers) reconstitute portfolios into other long-term assets, raising a wider set of asset prices.
  • European equity prices remain well below pre-crisis levels; QE can help lift them.
• Balance sheet and credit supply effects:
  • Household and corporate balance sheets: higher asset values and lower real carrying costs of debt help reverse balance sheet recession dynamics where households and firms cut back to pay down debt.
  • Bank capital: banks are major holders of sovereign bonds; higher sovereign bond prices raise bank valuations. Example given: a 50 basis point fall in long-term yields could raise the banking system’s core tier 1 capital ratio by 1½ percentage points.
  • Collateral values: higher private asset prices raise household and firm collateral values, increasing banks’ willingness and ability to supply credit.
• Credit demand:
  • Increased aggregate demand from higher asset values and growth expectations would increase credit demand.
  • QE works to restore both supply and demand for bank credit—unlike prior ECB measures.

Effectiveness in a low-rate, bank-based system

• Empirical reference: QE worked in Japan despite a bank-based financial system (Japanese finance: 83%) similar to Europe (89%).
• Comparative scope: There is more space for the euro area yield curve to fall than there was in Japan.
• Plausible yield impact: A decline in European yields of 50 basis points at mid-maturities, and more at the longer end, is described as entirely plausible.

Why the ECB has not embraced QE fully

• ECB stance: Open to unconventional measures but has judged circumstances do not yet justify QE.
• Implementation risk: QE must be implemented with full conviction; partial or premature programs are ineffective.
  • Historical Japan lessons:
  • BOJ QE in the early 2000s ended prematurely (before inflation and inflation expectations durably rose).
  • BOJ QE in 2010–12 was too guarded (small steps, no clear link to inflation goal).
  • BOJ QQE since 2013 was “whatever-it-takes” on size, pointed on goals and timeframe, and yielded a strong response in inflation expectations.

Side effects and their management

• Risk-taking and credit growth:
  • QE pushes investors out of safe government bonds toward riskier lending—this is intended, but could lead to excessive risk-taking eventually.
  • Current assessment: not an immediate risk relative to the danger of too-low inflation; credit is still contracting in the euro area (barely positive even in Germany) and there is no evidence of housing/asset bubbles (not even in Germany).
  • Response: targeted macro-prudential measures can be deployed if bubbles emerge; these tools need further development.
• Currency effects:
  • QE would likely weaken the euro, which could help raise demand and traded goods prices and therefore combat low inflation.
  • Depreciation is not inevitable: stronger asset prices and economic prospects from QE could attract capital and appreciate the euro.

Reza Moghadam, Ranjit Teja; July 14, 2014.

Content in this bundle

• Country Report
  • Country Report (Markdown version)
  • Country Report (PDF)

References

• https://www.imf.org/wp-content/uploads/2014/07/qe-blog-2-001.png
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• https://www.imf.org/wp-content/uploads/2014/07/qe-blog-2-008.png
• https://www.imf.org/wp-content/uploads/2014/07/qe-blog-2-009.png