In March the European Union began its quantitative easing (QE) program 6 years after the US. The EU has long been viewed as a prime candidate for QE following the GFC. However the European Central Bank (ECB) has dragged its feet on its execution due to the intricacies of rolling out such a program in a union situation where monetary and fiscal policy are managed at different levels.
Initially the European Central Bank’s (ECB) QE program was to purchase government bonds at a monthly rate of 60 billion euros until the end of September 2016. Like in Japan and the US, the ECB hoped QE would push bond yields lower so that borrowing costs across Europe decreased. Taking learnings from the US successful QE3 program the ECB announced a plan to target not just government borrowing costs but household and business borrowing costs too. Eventually this program was hoped to raise inflation to the ECB’s target of 2% (a rate not actualised since 2013).
How will QE work in an a union situation
Uniquely the actualisation of this involves the ECB buying government bonds in the secondary market. Law in the EU prohibits the ECB buying bonds directly from the issuing governments., adding more complexity and ambiguity to the process. So the ECB has to compete with companies and other countries (like the US and Japan) to buy bonds. This could create an incentive problem. For example, say Italy issues a government bond, the demand for this bond is now multiplied so the ECB may have to pay more for these bonds than it would if it did not have to enter the secondary market. The result has indeed been soaring costs to borrow government bonds. This has reduced the stock of repurchase agreements in the overnight bond market, limiting liquidity.
Controversially, the ECB has decided it will not release information to the markets about how much it has paid for the bonds or what countries it has purchased the bonds from. The secrecy behind this move is unique to the union situation and may eliminate the usual positive effects on expectations QE has.
The outcome before recent Greece bailout talks
Unsurprisingly, governments have started to issue more bonds since the announcement of the ECB’s QE program. As we cannot know for certain what country’s bonds have been bought it is hard to pin down how each country is affected. Focusing on German bonds can give some insight into how QE affected the EU before recent Greece talks. Expectations of QE alone were able to push German short-run bonds yields to 0.3% (compared to 2.1% yield of equivalent U.S.) and five-year German bonds to negative territory, easing budget pressure on the European governments who have borrowed from Germany.
QE in the EU like in the US has been accompanied with depreciation of the Euro currency. It is now at a decade low of $1.11 to the US dollar. This means EU exports are now relatively cheaper and imports relatively more expensive. This boosts the EU GDP equation. Cheap money was also pushing investors into stock markets in search of better returns. European markets had been (before the recent Greece bail out talks) experiencing an almost bull like run.
The outcome now
Unfortunately, the recent uncertainty around Greece has thumped the success QE had. Countries like Spain and Italy that are most exposed to Greece’s issues have seen bonds yields shoot up to a level not conducive to the objectives of QE. As bond yields are negatively correlated with the ability for European governments to meet their budget goals the continued contagion from Greece will undermine QE. This leaves the ECB in a perilous position, it must increase and extend QE as seen in Japan and the US. This shows that QE does not solve a broken economy. This signals that the EU will more likely follow the path of Japanese QE than US QE and it is likely the EU will not be able to get off the QE drug anytime soon. As it stands now QE is life support for a European economy that has more critical issues underlying the dynamics, it is hard to believe QE alone can be a long term solution.