In this quarterly report we take a closer look at the recent move by the European Central Bank to engage in Quantitative Easing. This was a major development in the first quarter of 2015 and will have implications for the region for a considerable period. We will look at key questions, including;

  • Why has the European Central Bank decided to implement Quantitative Easing now?
  • How will the programme work across the different economies?
  • What impact has it had already?
  • Will it work?

Why is the ECB doing QE?

The Euro Area has struggled with lacklustre economic activity for years, and more recently fears about deflation have increased, pushing the European Central Bank (ECB) into Quantitative Easing (QE). You can see from the chart below that inflation has fallen into negative territory. Even before the sharp oil price drop from the middle of 2014, inflation was still below 1% due to weak demand and activity levels. Having cut the main interest rate (the refinancing operations rate) to just 0.05% throughout 2014, the central bank also employed a range of other options before embarking on QE. These included Targeted Longer-Term Refinancing Operations (TLTROs) to encourage banks to increase lending, and in September 2014, the ECB began buying covered bonds and asset backed securities, a pre-cursor to outright QE.

The hope is that Quantitative Easing will stimulate economic activity by encouraging banks to increase lending. The US Federal Reserve carried out a similar programme of QE which began in November 2008 and eventually increased the size of the central bank's balance sheet from around $870bn to $4.5 trillion today.

How will the programme work?

On 9th March 2015, the ECB began its purchases under the scheme of Quantitative Easing, called Public Sector Purchase Programme (PSPP). The ECB, together with the national central banks of the Euro system will purchase EUR60bn per month in public and private sector securities – this includes the already operational ABS and covered bond purchases. Sovereign bond purchases will be approximately EUR40bn per month. The ECB has committed to the programme until at least September 2016, which implies expansion of the central bank's balance sheet by more than EUR1 trillion (see chart below).

The ECB expanded its balance sheet aggressively towards the end of 201, thanks to Targeted Long Term Refinancing Operations – these were cheap loans to banks to help boost cash flows and avert a serious credit crunch. This current round of QE should expand the balance sheet back to around the same level.

These QE purchases will be made in line with the ECB's capital key, which reflects country's share of the total EU population and GDP. This means around a fifth of purchases will be German assets (see table below). The ECB has said that it will not hold more than 33% of the debt from a single issuer or purchase more than 25% of any single issue. For Greece, this means the ECB will not be able to buy its debt until at least July when some of the debt it holds under a previous programme (Securities Market Programme) has been redeemed. On top of this, non-investment grade collateral will not be eligible for the programme - countries such as Greece and Cyprus will need to be under an assistance programme in order to be eligible.

Estimated Sovereign Bond Purchases 2015 (figures adjusted to exclude non-Eurozone members)

What impact has it had so far?

The beginning of Quantitative Easing in the US and the UK had the benefit of the "shock and awe" effect. This is partly because the monetary policy tool was somewhat unknown and also because the moves were relatively unexpected by the market. In contrast, the markets have been expecting Quantitative Easing from the ECB for some time, particularly since September 2014 when the central bank began buying covered bonds and asset backed securities. It was on January 22nd 2015 that the ECB announced it would introduce Quantitative Easing. You can see from the chart below the impact this had on both stock markets and the Euro. In the first three months of 2015, the STOXX index rose by around 18% and the Euro depreciated by around 9% on a trade weighted basis.

European Government bond yields have also fallen significantly. For example, in Portugal, the 10 year government bond yield has fallen by 100bp since the beginning of 2015 to1.69% at the end of the first quarter. The outlier has been Greece, where ongoing concerns about the political situation, and worries about and exit from the Euro Area, have driven yields up over the last few months, from 9.8% at the beginning of the year, to 11.6% at the end of the first quarter.

Will it work?

The financial system in the Euro Area is very different to that in the US and this may affect how Quantitative Easing works in the region. In the US, companies are much more reliant on capital markets for finance. They benefited much more from falling government bond yields as this pushed investors into riskier assets such as corporate bonds. In the Euro Area, companies rely more on banks for funding. So the boost to capital markets may not benefit them as much. The areas in which Quantitative Easing may be more successful in the Euro Area are through a weaker currency and improved sentiment.

By adopting QE, the central bank has sent a strong message that it is prepared to do whatever it takes to support the economy and meet the 2% inflation target. Already, we have seen an improvement in business and consumer sentiment which is likely a result of QE. The sharp bounce in stock markets is also indicative of improved sentiment. On top of this, the sharp Euro depreciation will help make Euro Area exports more competitive, in turn supporting economic growth. A weaker currency also increases import costs and should help to push inflation higher.

One criticism of the ECB has been that it initiated Quantitative Easing too late. When the ECB announced QE in January 2015, headline inflation had already fallen to -0.6%. However the ECB are confident that its measures will positively impact the economy. Recent ECB staff projections show that it expects economic growth to reach 1.5% in 2015, up from its December forecast of 1.0%. Growth is then expected to accelerate to 1.9% in 2016. Inflation is also expected to rise, from zero in 2015, to 1.5% in 2016 and 1.8% in 2017.

ECB Staff Macroeconomic Projections (March 2015)

Only time will tell whether Quantitative Easing will sustainably boost economy activity and lead to higher inflation. The ECB has committed to the programme until September 2016. If growth and inflation meet expectations, as laid out in staff projections, it would suggest no need for further stimulus. However, the risk remains that further stimulus may be required at some point, as happened in both the US and UK.

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