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European Central Bank Embraces QE, For Better Or Worse |
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FORECASTS & TRENDS E-LETTER IN THIS ISSUE: 1. European Central Bank Announces Quantitative Easing 2. Why QE Bond Buying May Not Work in Europe 3. ECB Bond Buying Will Devalue the Eurodollar 4. IMF Cuts Global Growth Forecast For 2015/2016 5. World Bank Cuts 2015 Global Economic Outlook European Central Bank Announces Quantitative Easing Last Thursday, European Central Bank (ECB) President Mario Draghi announced the much-anticipated launch of a sovereign bond buying program at the rate of €60 billion ($70 billion) per month known as “quantitative easing.” The amount of the monthly purchases was slightly higher than had been expected.
The long-expected introduction of Eurozone government bond purchases, which could in total amount to as much as a trillion euros ($1.3 trillion), means that the ECB will join the US Federal Reserve, the Bank of England and the Bank of Japan in launching a quantitative easing (QE) scheme. The program will be open-ended, lasting until at least September 2016, Draghi told reporters at his regular media conference last Thursday, and will start in March of this year. The ECB’s hope is that it will boost the region’s painfully low inflation rate, which came in at an annual minus 0.2% in December. Explaining the ECB’s decision, Draghi said: “Inflation dynamics have continued to be weaker than expected. While the sharp fall in oil prices over recent months remains the dominant factor driving current headline inflation, the potential for second-round effects on wage and price-setting has increased and could adversely affect medium-term price developments.” The ECB will purchase euro-denominated sovereign debt issued by Eurozone members. The vast majority of the QE purchases will be subject to risk-sharing arrangements with other European national banks designed to limit the amount of risk the ECB takes on its balance sheet. Again, the monthly bond purchases will commence in March. The question is whether the ECB’s QE bond buying program will be successful in boosting the European economies and heading off deflation. While the size of the monthly bond purchases was slightly larger than initially expected, the ECB will be limited to buying a maximum of 17% of Eurozone sovereign debt offerings. That compares to 21% purchased by the US Fed and 27.5% by the Bank of England in their respective QE programs. When making such comparisons, the obvious question is whether or not the QE bond buying programs in the US and the UK really worked. Some say the respective QE programs served to head-off a depression-like disaster in 2008. Others argue that these massive QE programs did little to reverse the effects of the late 2007-early 2009 financial crisis. I will discuss the likelihood that QE in Europe will work, or not, below. Whatever the outcome, the ECB has now used the last tool in its toolbox. Why QE Bond Buying May Not Work in Europe Central banks in the US, England, Japan and now Europe are fully invested in the theory that zero interest rates and bond buying are stimulative and add to inflation. Yet growth, inflation and median incomes keep going down. And deflation is spreading in several European countries. There are several reasons to question whether QE will work in Europe. One of the main goals of QE is to bring bond yields down; however, 10-year bond yields in France and Germany are already near zero, at 0.55% and 0.37% respectively. Maybe they are headed in the direction of the Swiss National Bank which last week abandoned its currency peg to the euro and now charges depositors 0.75% to hold reserves at the central bank. Another negative side-effect of the ECB’s large bond buying program is that it may give European governments a further excuse to delay or avoid real economic reforms. Central bankers should be forcefully urging their governments to pursue practical growth-oriented solutions that encourage private investment and hiring. Instead, they’ve finally decided to embark on an ambitious quantitative easing program – even though QE hasn’t worked as expected where it’s been tried. US, UK and Japan central-bank balance sheets have grown by an extraordinary $7 trillion since the 2008 crisis. Yet many parts of the world are in or near recession, including Japan, Latin America, Eastern Europe and most of the Eurozone. As I will discuss below, the World Bank and International Monetary Fund have just lowered their 2015 global growth forecasts, and the IMF knocked more than $5 trillion off its October estimate of 2015 world GDP due to recent declines in commodities and currencies and the slide toward deflation.
A better approach would be to promote growth the old-fashioned way, through tax cuts, robust after-tax profits at small businesses, investment in startups and more jobs. In most of the developed world, that kind of growth has been on hold, waiting to find a path through political and regulatory obstacles. The risk, as inflation rates fall into negative territory, is that central banks will double-down on their current set of ineffective policies, making matters worse and allowing recessions and deflation to spread. The US consumer-price index fell 0.4% in December, the largest decrease in six years, and is on track for another large decline in January. As a result, the Federal Reserve is sending signals that it may delay rate hikes this year, even though six years of near-zero rates haven’t produced satisfactory growth or price stability. But that’s a topic for another time. It remains to be seen if the €60 billion monthly bond purchases will reverse the deflationary forces unfolding in Europe. However, there is rather broad agreement that the QE program will do little to boost growth in the Eurozone and may not help those countries most in need of it. ECB Bond Buying Will Devalue the Eurodollar The other problem is the euro currency itself. The ECB will be using QE to promote the devaluation of the euro as a way to make up for Europe’s uncompetitive tax and regulatory policies, much like the Bank of Japan has done with the yen – which unfortunately did not result in the desired increase in growth. Here, too, the euro has already devalued significantly against the US dollar just in the last year.
The ECB’s primary mission is to reverse deflationary forces now unfolding and increasing inflation to around 2% (if that is possible). The last time that Eurozone consumer price inflation (CPI) was measured at 2.0% was December 2012. Indeed it has been under 1.0% percent since September 2013. The central bank is apparently willing to see the euro move even lower against the US dollar and other major currencies. As you can see in the chart above, the euro is not far from parity with the US dollar. Devaluing one’s currency may stimulate manufacturing and exports by making Eurozone members’ products and services cheaper overseas, but it also makes imports more expensive for all of the member countries. In summary, it is questionable whether the ECB’s ambitious bond buying program will be successful in reversing deflation and increasing inflation to its 2% target over the next two years. Bond yields are already extremely low, so it is not likely that QE alone will stimulate any significant economic growth or new jobs. And it will almost certainly further devalue the euro. If Europe’s QE plays out remotely as it did in the US, it will primarily benefit the wealthy – in terms of higher stock prices and home prices. Savers will be punished from even lower interest rates, some of which could actually go negative before long. Those who regularly purchase imports will see their prices rise, perhaps significantly. Despite that, there was quite a buzz in Europe late last week when the ECB made the announcement of its aggressive QE bond buying of €60 billion a month until at least late 2016. A year from now, we’ll have a better idea of how it is working, or not working. I certainly have my doubts! IMF Cuts Global Growth Forecast For 2015/2016 On January 19, the International Monetary Fund (IMF) trimmed its global growth forecast for 2015 and 2016, cautioning that the boost from lower crude oil prices would be offset by dimmer economic prospects for China, Russia, the Eurozone, Japan and oil-producing countries. In its latest “World Economic Outlook Update,” the IMF projected the global economy would expand by 3.5% this year and 3.7% next year. While those numbers might look encouraging, they are lower than the IMF’s October forecast of 3.8% and 4.0%, respectively. The IMF stated: “Global growth will receive a boost from lower oil prices. But this boost is
The IMF pointed to Europe and Japan as the most obvious areas where downside risks remain higher. Assuming no negative surprises, the IMF forecasts growth of 1.2% for the Eurozone and 0.6% for Japan – but it admits that both estimates could be too high. Russia received the sharpest downward revision of any other country, to a contraction of 3% in 2015 from its previous forecast for a 0.5% expansion, reflecting depressed crude prices and increased geopolitical tensions. The IMF also downgraded its forecast for China which is expected to slow further to 6.8%, down from 7.4%, the slowest pace in 24 years. The world’s second largest economy is reorienting towards consumption and away from the real estate sector and shadow banking. Slower growth in China will also have important regional effects, which partly explains the IMF’s downward revisions to growth in much of emerging Asia. World Bank Cuts 2015 Global Economic Outlook The World Bank, a United Nations international financial institution, also lowered its global economic forecasts earlier this month. On January 13, the bank revised its estimate for 2015 global growth to 3.0%, down from its 3.4% forecast last year. The bank cited disappointing economic prospects in the Eurozone, Japan and some major emerging economies – all of which were downgraded. “After growing by an estimated 2.6 percent in 2014, the global economy is projected to expand by 3 percent this year, 3.3 percent in 2016 and 3.2 percent in 2017. Developing countries grew by 4.4 percent in 2014 and are expected to edge up to 4.8 percent in 2015, strengthening to 5.3 and 5.4 percent in 2016 and 2017, respectively.”
The World Bank reaffirmed its position that sharply lower energy prices are a positive benefit to the global economy, but it also warned that oil prices at today’s level will serve to depress inflation and in some cases, lead to deflation in certain regions of the world. The bank listed four specific risks that lead to the downward revision for global growth. The first is persistently weak global trade. The second is increasing financial market volatility. Third, the bank warned of financial strains among oil producers. Fourth is the risk of a prolonged period of stagnation or deflation in the euro area. In summary, both the IMF and the World Bank forecast that the global economy will expand by at least 3% in 2015 and 2016, led primarily by the US. However, the latest forecasts are a downward revision from their previous forecasts in 2014. Greece: Radical Syriza Party Win Means More Chaos The Syriza Party candidate Alex Tsipras was elected Prime Minister on Sunday by a reportedly comfortable margin. Tsipras ran on a promise to roll-back the severe austerity measures imposed by the European Union in May 2010 in return for 240 billion euros ($269 billion) in a rescue package. Tsipras also pledged to restructure Greece’s debt with its EU peers, including write-downs on some of the debt. Some fear that if the EU does not agree to such a debt restructuring and a scale-back of austerity measures, Tsipras and his new coalition could decide to withdraw from the EU, which could cause chaos in the European financial markets over the coming months. Some argue that Greece’s withdrawal from the EU could mean the end of the euro (see article below). Investors must now wait for Tsipras to spell out how he plans to negotiate Greece’s future financing needs. An extension of the current euro area-backed bailout program expires at the end of February, with Greece projected to run out of money by July at the latest. So look for more fireworks coming out of Greece just ahead! Very best regards,
Gary D. Halbert
SPECIAL ARTICLES Larry Summers: Europe, US on Brink of Deflationary Spiral Greek elections may be the beginning of the end for the Euro
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Central bankers apparently believe deflation can still be halted by what Milton Friedman once called a “helicopter drop of money,” but it isn’t clear they have the right tools. As noted above, central bank reserves in the US, UK and Japan are already in massive excess. Adding more, as the ECB is expected to do, probably won’t add growth, and it remains to be seen if it will reverse spreading deflation.
The US was the only major economy to receive an upward revision to growth from the IMF. The IMF expects the world’s largest economy to grow by 3.6% this year, up from a previous forecast of 3.1%, with domestic demand supported by lower oil prices and an accommodative monetary policy stance by the Fed. But that’s where the good news stops.
Among emerging markets, Russia and Brazil in particular weighed on the bank’s global growth predictions, along with China, which is in a managed slowdown as it transitions away from an investment-led growth model.
