The ECB is beginning to face a QE dilemma

A feature of these times is the contrary nature of the economic debate. Currently headlines are being occupied by promises by the US Federal Reserve and Bank of England to raise interest-rates and tighten monetary policy. However more of the world’s central banks will be considering an easing of policy or in the case of China another easing. If we put the problems of the Bank of Japan to one side there is the position of the European Central Bank which is currently engaged in a 1.1 trillion Euro Quantitative Easing program scheduled to last until September next year. Thoughts on this have gone full circle because some decided that it would end the program early or taper it whereas now there is an increasing groundswell of opinion that it will do more. This is mostly in the form of the same rate of purchases (around 60 billion Euros per month) but for longer although some want an increase rate of purchases.

What exactly is the ECB doing?

As of the end of last week the ECB had purchased some 289.5 billion Euros of sovereign bonds, 111.1 billion Euros of covered bonds to support banks and the mortgage market and 11.1 billion Euros of Asset Backed Securities. Those who follow the situation may be wondering why ECB President made such a big deal of relatively little in the case of ABS purchases but there you have it. The weekly rate of purchases is fairly consistent and last week it was 11.6 billion Euros.

The first thing this is supposed to achieve is this.

First, large-scale security purchases mechanically reduce the supply of securities available in the secondary market, which results in higher prices and lower yields through the creation of scarcity. Importantly, this effect is by no means limited to the individual bonds that are purchased.

So bond prices should be higher and yields lower. However in practice this is not so easy to determine. Currently the German ten-year yield is some 0.8% which is ten times that of the low reached in mid-April! This is a not unfamiliar pattern for QE programs where expectations feed into the initial reality but then the improvements fade away. So yes yields are lower overall now but 0.8% for Germany compares with 1.1% a year ago. This is much lower than the estimated gains from Bank of England research in 2011/12 but of course German yields were much lower in the first place.

Perhaps a clearer picture can be found in Italy as there is no way that its ten-year bond yield would be 2% without some official support. So we can conclude that sovereign and related yields are lower than they would otherwise be. However this is supposed to feed into other asset prices and particularly equities and this has become a more awkward area since the 12% fall in the Eurofirst 300 index in August which has been accompanied by further falls so far in September. At 1388 it is still higher than when QE began but not by much as we stand.

Inflation Inflation

In the context of the euro area economy, which is largely bank-based, we would expect banks to shift their portfolios from bonds to riskier investments such as loans to firms and households.

Ah the “precious” which always gets support from a central bank. Via this route we are supposed to see rises in inflation and growth. Those who are not central bankers are likely to be dubious about the benefit of higher inflation but there you have it.

How is it going?

In terms of the monetary system then there are signs of an impact.

The annual growth rate of the broad monetary aggregate M3 increased to 5.3% in July 2015, from 4.9% in June…..The annual growth rate of the narrower aggregate M1, which includes currency in circulation and overnight deposits, increased to 12.1% in July, from 11.7% in June.

So the efforts of the ECB have pushed money supply growth higher and loans to households (1.9% annual rate) and loans to businesses (0.9% annual rate) rose too.

If we look at economic growth then the ECB would be happy with the 0.4%,0.4% and 0.3% of the last three quarters and might even be following one of the leaders in that pack by doing an Irish jig! It may be not so pleased about the latest dip however marginal and of course it is true that lower oil prices have also contributed. If we look forwards we see that some growth is expected.

Based on the historical relationship, the (manufacturing)PMI is tracking at somewhere close to a 2% annualised increase in industrial production so far in the third quarter.

Of course we have limited data so far but the expectation is as shown below.

GDP growth is tracking close to 0.4% so far in the third quarter

At this point you might reasonably be wondering why there is any talk at all of further easing.

Currency Wars

The conventional economic line of thought suggests that QE leads to a lower currency and for a time that was true. To be specific the expectation of ECB QE helped the Euro fall. However in recent times the pattern has changed. UK holiday makers may rue that fact that the 1.44 of mid-July has been replaced by the below 1.36 of now but the Euro has been strengthening overall.

In trade-weighted terms the Euro has risen from a low of 88.7 in mid-April to 93.8 now meaning that policy has tightened rather than relaxed over this phase.

What about inflation?

This mornings numbers tell us that there remain disinflationary pressure in the system.

In July 2015, compared with June 2015, industrial producer prices fell by 0.1% in the euro area (EA19)…In July 2015, compared with July 2014, industrial producer prices decreased by 2.1% in the euro area.

The annual rate of consumer inflation remained at 0.2% in the Euro area in July. Added to this the rather arcane world of five-year inflation swaps which the ECB unwisely highlighted have headed back to the sort of levels they were at when the new QE program began.

The official view expressed at Jackson Hole is that things are on track but of course we know that beneath the hype central banks are poor at foreseeing things. It is also true that the recent wild swings in the price of crude oil (down 8% yesterday after sharp rallies) make matters especially cloudy looking forwards.


In many ways the ECB might have hoped for a summer lull to allow its QE program to grow and progress. If it had known the economic growth position alone then it might have been happy right now. However it has been in the past the keenest of the major central banks to hit its annual inflation target. I still recall the previous President Jean-Claude Trichet boasting about an average annual consumer inflation rate of 1.97%. In those terms the current one of 0.2% and no great expectations of much of a rise anytime soon is rather eloquent.

I do not expect a move tomorrow as the ECB usually likes to signal ahead in terms of hints so I hope that its language avoids the dangers expressed by Led Zeppelin .

Communication Breakdown, It’s always the same,
I’m having a nervous breakdown, Drive me insane!

Or by the Who.

Got a feeling inside (Can’t explain)
It’s a certain kind (Can’t explain)
I feel hot and cold (Can’t explain)
Yeah, down in my soul, yeah (Can’t explain)


9 thoughts on “The ECB is beginning to face a QE dilemma

  1. doesnt seem a problem at all Shaun

    the Banks are bust and to keep them afloat and to stop another 1930’s asset depression they will be print print print all the way

    and it helps with a little matter of Greece , I mean do they owe the IMF anything now ?


    • Hi Forbin

      It helps with Greece indirectly as of course it does not qualify for ECB QE partly because the ECB ended up owning so many Greek bonds! It is far from impossible that later this we will see Greece added as there have been some hints.

      The IMF records the Greece owed it some 15.27 billion SDRs (Special Drawing Rights) at the end of July. It should be less now as it was able to repay some money when the EFSM and ESM stepped in, a couple of billion or so less I think?

  2. Shaun, what do you think is driving the increase in value of the Euro? Is it funds from China? If so I would have thought that Stirling and the Dollar would also have benefitted. I am struggling to rationalise what is going on.

    • Hi Pavlaki

      The US Dollar has not been the perceived haven this time around has it? As I note that the Japanese Yen has been having a strong phase too (120 as I type this but it had a surge towards 117 just over a week ago) I am reminded that the Carry Trade looks as though it has been in evidence again.

      Swiss readers will have a wry smile at some of the Carry Trade influence shifting to the Euro as it has risen against the Swiss Franc too.

  3. Hi Shaun,

    We seem to be entering a bear market with increased volatility giving small rallies in an overall declining equities market. If the US catches a cold it will be a few months before the European markets start sneezing. Will the ECB then follow the Fed is trying to go to QE infinity and beyond?

    I think the oil rally was a false dawn, with no signs of supply matching demand and the Saudis affirming the continuation of their protecting market share policy. Russia is pumping record amounts, where they are trying to use increased volumes to stop revenue declines and we still have increasing Iranian oil production to come on stream.

    I can’t see the BOE forward guessing, sorry guidance, being anymore accurate this time than on any previous occasions when we have heard the howl of the rate rise wolf!

    • Hi Rods

      There are many questions at the moment. Today’s beige book in the US calls the expansion either moderate or modest which sets a tone. What if they raise and then there is a dip? Added to that others (ECB and BoJ especially) may well ease more. It could be quite a mess.

      As to equities it does feel like that, I think that we will see the recent lows again before this is over.

      • In a control system you have negative feedback to prevent ‘hunting’ and to get to a stable state. As it approaches stability the control changes to the system get smaller and smaller. The perfect fuel level/rudder angle/aileron angle is never reached as the system is moving anyway so many small changes are occurring in the controls at the more or less stable state.

        Why don’t central banks do the same? Nudge interest rates up (say) 0.1% and see what happens. Next month nudge it again and so on. Nothing disastrous happens and if a bad trend starts then nudge it down.

        Not only is there a fine control but a lot of useful statistics come out of it and it will kill off all the counter-factual arguments which suddenly can be refuted.

        0.5% for 6 years is no help at all.

        • The problem with economics (and climate) is that there is a formula based mathematical element and a random element. The random element can be part described by behaviour and part by catastrophe theory, but by the very nature that they are random you only know they have occurred after the event! Which is why there is such a large element of guess work. Economists seem to have a reasonable chance of being in the right ball park during reasonable steady state times, for the rest of it, forget it.

          Whereas a traditional control system, provided the system stays within design limits it has predictable actions and feedback. On feedback systems there are always two elements steady state error and lag between the system generating an error and the feedback correcting it. Lag is a critical component for stability. I can remember when I did this at college the maths was horrible where you had to find standard solutions to multiple partial differential equations.

    • The US is likely to struggle next year despite most forecasts of >2.5% growth. I have ben predicting a rate rise this September since September 2014 but US money supply and inventory numbers I’ve been looking at over the last 3 months tell a different story and I hope the Fed does nothing for another year. If they raise there will definitely be a dip.

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