Originally published on Jan. 20, 2015
On Thursday, the ECB is expected to announce a government bond-buying program of the size of €550bn. Maybe it is because I am German - and Bundesbank president Weidmann has always been one of the most outspoken opponents of QE - but I am skeptical that a QE program will do the work in Europe. I thus want to take the opportunity and shed some light on the arguments in favor of QE and discuss if they are justified.
QE Will Prevent Eurozone From Falling Into Deflation
This is actually a pretty weak argument in my view. It is true, headline inflation was -0.2% in December, but core inflation is still far enough from zero. In fact core inflation, which excludes more volatile items such as energy (oil!) and food, edged up slightly in December to 0.8% from 0.7%. Core inflation today is as low as it was in October 2013 and yet since then Europe has not fallen into outright deflation. The risk of such is also very low as core inflation is much more sticky. This is also in line with what Mr. Weidmann said in December. So, it is important to note that the Euro Area is not in deflationary territory. The lower oil price should instead act as a boost to GDP as people, instead of spending their money on gasoline, will spend it on more discretionary goods and services such as going to the restaurant or the cinema.
In fact, periphery countries need a certain degree of deflation. In order to regain competitiveness, prices and wages have to fall relative to core countries. Spanish officials have already stated that the country should run an inflation rate below the Eurozone average. However, this would be a lot easier if core countries had higher inflation rates than they do now. The point where it gets dangerous is when consumers start postponing purchases because they expect prices to fall, which leads us to the next point.
QE Will Lift Inflation Expectations
Measuring inflation expectations is not that easy. Most people might have an idea if prices are going to go up or down, but putting a number on the expected change in prices is much more difficult. What we can do is look at the price of inflation swaps. However, the shortfall here is that it only measures the expected inflation of investors but not of consumers. Looking at the Euro Area 5-year forward inflation swap we see that the price has fallen off a cliff recently. According to this chart, investors expect inflation in 5- years to still be well below 2% at around 1.5%.
There is another way to measure expected inflation that is more linked to consumers' expectations. The EU Commission produces a monthly survey of inflation expectations among consumers. The measure ranges from -100 to +100. Thus, we cannot say what current inflation expectations are, but at least we have an idea of the direction of price changes. The latest survey paints the same picture as the inflation swap with consumers expecting only minimal price increases over the coming 12 months.
|Source: EU Commission|
So a fair conclusion would be that inflation expectations have been decreasing. However, the more interesting question is whether a QE program can lift inflation expectations. Let us have a look at the US, a country in which QE is believed to have worked. The Federal Reserve Bank of Cleveland reports monthly estimates of 10-year expected inflation. The latest estimate of 10-year expected inflation is just 1.65%, not too far from the 1.5% expected over the next five years for the Eurozone that can be extracted from forward inflation swap contracts. It is important to note the difference here between the two measures: the swap measures expected inflation in 5 years whereas the Cleveland Fed measure is for 10 years. Even after years of large-scale QE, inflation expectations in the US are still on the decline. This casts significant doubts on whether Euro Area QE can be successful in this field. Why should it work in the Eurozone if it did not work in the US?
|Source: Cleveland Fed|
QE Will Make It Easier For Corporates To Borrow Money
The underlying logic behind this is that if the ECB buys government bonds, hence pushing yields lower, investors will search for yield elsewhere. This elsewhere would be investment grade corporate bonds. Also high-yield bonds should see some gravitational pull from a big sovereign bond-buying scheme. Lower bond yields should make it then easier for companies to borrow money and invest. In theory this sounds like a good idea and it will probably work for the corporate bonds that are traded. The only problem is that in Europe, as opposed to the US, companies highly rely on bank loans rather than issuing debt securities. This is especially true for small and medium-sized companies. Thus the effect will be more marginal.
|Source: Deutsche Bank Research|
- The Eurozone is not in deflationary territory and there is no risk of falling into outright deflation
- Inflation expectations have been decreasing but it is doubtful if QE will lift them
- The effect on corporate financing costs will be only marginal