European Central Bank (ECB) President Mario Draghi has announced that the central bank will purchase sovereign debt along with agency debt in order to combat the rising risk of deflation. Despite considerable doubts from Germany, the ECB will follow in the steps of the Federal Reserve, Bank of Japan and Bank of England by introducing quantitative easing (QE) - expanding its balance sheet in an attempt to weaken the euro and raise domestic demand.
Draghi announced that the new additional purchases combined with the existing asset backed securities (ABS) and covered bond purchases will total €60 billion per month starting from March until September 2016 - totalling €1.1 trillion (11% of GDP), or roughly what is required to take the ECB’s balance sheet back to the peaks seen in 2012. This is about twice the size expected by the market consensus and as a result, the euro is trading lower against the US dollar and sterling, while European government bonds are seeing falling yields (rising prices).
Eurozone inflation fell below zero in December and is very likely to fall further in coming months thanks to falling energy prices. While we see this as a positive development for growth and medium-term inflation, in the near-term at least, there is a risk that households’ inflation expectations become de-anchored and they start behaving in a more deflationary manner. If households start to believe that prices will continue to fall, they may be tempted to hold back spending to achieve lower prices, which in turn will push prices down further thanks to the lower demand. This would reinforce the lower price expectations, and cause a downward spiral in prices – Japanese style deflation. This is not our central view, and today’s action from the ECB further reduces the risk of deflation.
The obvious question is will QE make a difference, especially as government bond yields in Europe are already so low? There is certainly scope for bond yields in peripheral Europe to fall further, and for those lower interest rates to feed through to the real economy via the banking system, however, we feel that the main impact will come through from the weaker euro, which will make European exporters more competitive internationally.
The issue of risk sharing in the event of losses was also answered today. Germany appears to have been against the idea of any risk sharing should an issuer look to default on the bonds purchased, but markets were concerned that without risk sharing, the programme would lose any credibility. In the end, the ECB has decided to share the risk on 20% of the purchases, with the remaining covered by individual central banks.
Importantly, the ECB has stated that it will only purchase investment grade debt, with an option to buy the debt issued by lower rated sovereigns for those in a bailout programme. This covers the ECB should the Greek election this weekend result in a government that seeks to end Greece’s bail-out programme. Finally, the ECB announced that it would stand equal with private investors should losses be incurred (pari passu), which reduces the incentive of forced restructuring.
Overall, we think the ECB’s QE programme will benefit the Eurozone economy by reducing the risk of deflation; however, it is not a panacea for the monetary union’s ills. Deep structural reforms are required in order to raise Europe’s potential trend growth. Without structural reforms, the ECB may be forced to add additional stimulus in the future as growth falters again.
