The ECB And Balance Sheet Expansion: Why The Approach Is Misguided

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Includes: EU, VGK
by: Discount Fountain

Summary

With a balance sheet target of €3 trillion, the ECB is continuing to take quantitative easing measures to bolster economic growth.

I argue that this approach is misguided. A low interest rate policy with no indications of a possible tapering date will create confusion pertaining to price expectations.

While the purpose of QE is to bolster consumer spending, GDP across the Euro area remains low and deflation appears to be a risk.

With economic growth in the Euro area lagging that of many other nations, the ECB has adopted a low interest rate policy to boost markets. While this has helped stock market growth to some degree, GDP growth remains low, lagging behind major markets such as Canada, the United Kingdom and the United States:

Source: Trading Economics

Mario Draghi's goal of boosting the central bank's balance sheet to €3 trillion ($3.65 trillion U.S.) can only be achieved through further quantitative easing measures and this would run counter to the goals of many national central bank policies. Increasingly, the ECB appears to be running counter to its primary mandate of keeping inflation near a 2% level. While the Federal Reserve has traditionally insisted on policies emphasizing a good blend of economic growth with sustainable monetary policy, the ECB's mandate has traditionally been to keep monetary policy stable through the healthy regulation of inflation. However, the central bank's goal appears to be emphasizing growth at the expense of such monetary policy. In addition, quantitative easing is speculated to be aggressive - through the purchase of sovereign bonds if private-sector purchases prove to be insufficient. By the end of 2015, the balance sheet is expected to expand by €550 billion and this would rise to €850 billion by the end of 2016. With a current balance sheet level of €2 billion, the aim is to increase spending significantly to reach 2012 levels:

Source: Bloomberg

In a previous article, I had discussed that a low-interest rate policy had positive impacts on European markets. However, this did not translate into GDP growth. Moreover, we have seen that in countries such as Spain which is experiencing deflation at the present time stock market performance has outperformed certain countries with much healthier fundamentals:

Source: Yahoo Finance

Ironically, low interest rates carry the risk of inducing exactly what the ECB is trying to avoid: deflation. The idea behind what the ECB wants to achieve is simple - lower the cost of borrowing money and consumers will then spend it. Such an approach neglects the role of expectations in managing consumer spending. As a consumer, would it not be reasonable to assume that if I expect higher prices tomorrow, I am going to buy today? Instead, the ECB has provided no indication of when rates might rise. Given the lack of information, a consumer has more incentive to take the "wait and see" approach by letting prices bottom out before spending their wealth. In my opinion, the ECB has not been successful in managing inflation expectations, which in many ways have a greater impact on spending than inflation itself.

Given the above, I cannot say that I expect QE to end well for Europe. The data so far indicates that low interest rates have not boosted GDP growth and I expect that this will soon translate to stock markets in Europe. In my opinion, the ECB needs to refine its approach in terms of providing a definitive end date for quantitative easing - i.e. if Mario Draghi announces that quantitative easing will undergo a "tapering" or scaling back at the beginning of 2016, then this will encourage consumer spending in 2015 as consumers are at least armed with the knowledge that low prices will not be around forever. However, the lack of uncertainty in terms of price expectations will continue to keep consumer spending low.

To make a bold statement, I believe that the ECB is taking the wrong approach. The key idea of effective monetary policy is to encourage sustainable economic growth and current policies clearly are not doing so. Rather, continuing QE appears to be driven by fear of a negative reaction to sudden QE withdrawal and in this instance the continued uncertainty as to an end date for QE is not good for economic prospects long term.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.