Originally published on January 26, 2015
The big news last week was the European Central Bank's decision to embark on quantitative easing. While the move was widely anticipated, the size of the asset purchases was bigger than the market expected. According to the announcement, the ECB will purchase 60 billion euros of debt per month from March 2015 until at least September 2016.
The planned purchases amount to about 11% of euro-zone GDP, similar to the Federal Reserve's first round of quantitative easing. However, the ECB's QE is open-ended, which gives it the flexibility to continue the program as needed. Also, because its QE is open-ended, it can't be priced into the market as easily, which makes it more impactful. However, the ECB's decision raises a question that has been debated a lot since the start of the global financial crisis: "Is monetary policy-particularly unconventional monetary policy such as QE-really effective in stimulating an economy?"
Quantitative easing is defined as the management of a central bank's balance sheet in order to purchase securities - usually government bonds - and to remove them from the outstanding supply by taking them out of the hands of the public. It's designed to drive up prices and lower yields. In turn, that should give investors more cash. Hopefully, they either spend the money or invest further out on the risk spectrum, which should ultimately stimulate economic activity.
QE also helps to depreciate a central bank's currency, which makes exports more attractive and should stimulate the economy. That's what we've seen in Japan in the past two years. The concept of QE goes back to at least the 1960s, having been advocated by eminent economists James Tobin and later Milton Friedman. But it was never implemented by a central bank until the Bank of Japan launched QE in the 1990s.
In Ben Bernanke's 2012 Jackson Hole speech he explained, "Tobin suggested that purchases of longer-term securities by the Federal Reserve during the Great Depression could have helped the US economy recover despite the fact that short-term rates were close to zero" while "Friedman argued for large-scale purchases of long-term bonds by the Bank of Japan to help overcome Japan's deflationary trap."
In that same speech, Bernanke offered support for the argument that the type of unconventional monetary policy the Fed has employed in the past few years actually works-even though he admitted that there was very little historical experience to rely on. In terms of its impact on unemployment, Bernanke admitted that, "obtaining precise estimates of the effects of these operations on the broader economy is inherently difficult, as the counterfactual - how the economy would have performed in the absence of the Federal Reserve's actions - cannot be directly observed."
However, Bernanke cited a study based on the Fed's FRB/US model of the economy, which found that as of 2012, QE1 and QE2 "may have raised the level of output by almost 3% and increased private-payroll employment by more than two million jobs, relative to what otherwise would have occurred."
Not a Sure Thing
Still, there are no guarantees. Monetary policy is a blunt instrument, not a surgical tool; it indirectly impacts the economy. That's because a central bank can lower rates and buy bonds, putting more money into investors' hands. However, individuals and companies don't have to borrow and they certainly don't have to spend. Even though it's counterintuitive, individuals and companies can hoard cash in a low-interest-rate environment.
In addition, even if companies' sales increase, then they can try to operate without adding jobs or only adding part-time workers, who are less costly because companies don't have to pay for benefits. In other words, accommodative monetary policy can accomplish a lot or very little with regard to improving the employment situation. It depends on the economic environment and the market participants.
Today, a key ingredient in this equation is what I call "market participant psychology" or confidence. When consumers and companies don't have confidence, they don't usually spend. And, in the aftermath of the global financial crisis, monetary policy has accomplished far less than anticipated. Why? Because of the environment and the market participants, who lacked confidence and became far more risk-averse.
Will the ECB's brand of QE be as impactful? We believe that monetary policy alone is insufficient to improve the euro-zone growth outlook and that QE needs to be complemented by ongoing structural reforms. Nevertheless, with increasing signs of a cyclical acceleration in the euro zone-improving financial conditions (such as last week's ECB lending survey), lower oil prices and a depreciating euro - we're getting increasingly constructive on euro-zone risk assets. We believe the main risks for these assets are political. Yesterday's election in Greece does create a cloud, but we expect it to be temporary. Stay tuned as we follow this situation closely.