Last week the European Central Bank announced it will be softening the impact of the Quantitative Easing program, reducing the bond purchases from 60 to 30 billion euros per month from January 2018. The net asset purchases are intended to continue at least until September 2018 or beyond as the continent’ s strengthening economy has not yet delivered the sustained inflation rate of 2% (it was just 1.5 percent last month) and is not going to before late 2019 at the earliest. And even by 2019, inflation is expected only to reach 1.6 per cent, well below ECB’ s target to withdraw monetary stimulus.  The ECB also released further details on the reinvestments of maturing bonds alongside new QE purchases over the course of 2018. 

The QE around the world

Even though governments across Europe still face the uncertainty of precisely when the program will come to an end, ECB’ s decision is somewhat on the same track as other important central banks, that are finally starting cutting off the tap. Most economies are performing best than ever in the last decade and job markets are on path to full employment. The Fed is well ahead of the other central banks, with four rate hikes and a detailed plan to end the QE. China’s policymakers are expected to turning off credit growth next year as the country’s feared debt crisis now seems unlikely. The Bank of Japan keeps on enlarging its stimulus but still the rate of money printing will slow. The Bank of England just hikes rates for the first time in a decade. 

Figure 1: Cumulative Fed + ECB + BoJ + BoE balance sheets and 2018-2020 forecasts (Million US$)
Source: FRED, ECB, BoJ, BoE, retrieved from Credit Suisse Research

The total amount of Quantitative Easing adding up the balance sheets of the Fed, the ECB and BoJ is now around an extraordinary $14 trillion. The effects of such a flood of liquidity across the world on economic growth has been debated among experts but two conclusions are quite unanimously shared: the global financial collapse has been beaten off, even though with incredibly high costs, and assets such as stocks and bonds have been skyrocketing at record levels, still with all the risks included and with all the disagreements of whether or not financial stability is or should be an explicit consideration of monetary policymakers (what is being done to prevent financial instability in Europe here), adding to central bank’s dual mandate of low inflation and maximum employment. 

Figure 2: The divergence between FED balance sheets and the stock market.
Source: Bloomberg

That global quantitative easing has been crucial in supporting earnings growth through cheap money and helping economic expansion worldwide. Now that the FED, and lately in the future ECB (unlikely) and BoJ, is planning to unwind its massive balance sheet, investors are fretting whether it will pressure the stock market. The concerns about a liquidity doped bull market come from the fact that the QE has taken out yield from bond markets and fueled asset price appreciation, forcing investors to take increasing risk for lower expected returns. In other words, the link between QE and asset prices con be simplistically explained such as follows: Savings are always held in two places, cash and everything else (that is, the “financial assets”). The QE increases the supply of cash in the world (liquidity) and, by doing so, simultaneously decreases the supply of financial assets, by removing bonds from circulation. Those securities are replaced by the Central Bank’s cash of equivalent value so that the ratio of cash to financial assets increases. This relative abundance of cash available to purchase each unit of assets drives up the price of financial assets. This suggests that it if the flow of QE change, it influences the change in asset prices. When the cash flow is positive (easing), asset prices go up and when the cash flow is negative (tightening), asset prices go down. Even if it may seem intuitive, the relationship between balance sheets and asset prices is still a matter of disagreements. History teaches us that such transitions are frequently associated with such risk. But for the first time in history, we are about to experience a synchronized and global balance sheet reductions from the Central Banks around the world.  Surveys show that most investors share the concern that a monetary policy change might lead the the next recession. How investors will react to the end of this unprecedented stimulus? The answer is yet to be known.

Even though the QE has probably led to inflation in asset prices, as said, indeed it failed at bringing back demand inflation. According to the quantity theory of money, a faster growth rate in the money supply than real economic output should have produced inflation. As a matter of fact, it doesn’t seem to have had any effect on consumer prices and that is why most Central Banks are cautious to suddenly end the easing program. There could be several structural factors explaining such failure in price level increases, including broken credit transmission channels*, corporates focusing on minimising debt rather than maximising profit in recession, lowering wages and a lower than expected NAIRU** and slow recovery in consumer sentiment. After nine years of low-inflation, there are possibilities that inflation will be stating to substantially increasing again, as job markets get tighter and liquidity reaches small and medium businesses capable of crating jobs, as soon as banks re-start lending.

Figure 3: Source: World Economic Outlook, October 2017. Forecasts from 2016.


Figure 4: Source: World Economic Outlook, October 2017. Forecasts from 2016.

Among the effects of a withdrawal of the Fed, the ECB and the BOJ from the QE programs, the most concerning one is represented by the bond market, because the end of purchases will lead to an increase in the bond yields making the financing costs for the states higher. Upon the notion that people will continue to buy government debt, governments assume what worked before will continue. The increase in public spending is also due to interest rates being near zero and central banks being buyers of their debt. This raises the question: who, if not the Central Banks, will buy government debt in a bond market of rising rates (with bonds losing value)? Central Banks will probably have to wait for much of that debt to mature in order to reduce their balance sheets. But the problem is even more concerning in a politically disrupted and economically divergent Europe.

Figure 5: Output gap for the last quarter in Europe: Germany +1.7% & Italy -5.5%. How to apply a one-size-fits-all monetary policy?
Source: Goldman Sachs investment research

ECB preparing for normalization?

ECB cautious monetary policy decisions last week were based on a realistic assessment of the health of the eurozone economy. The continent’s economy is on track for its biggest economic expansion after the crisis.

Figure 6: Eurozone Real GDP. Source: FRED

Yet Mario Draghi says that “we aren’t there yet” on inflation, which was just 1.5% last month and which the central bank predicts won’t return to its goal of just under 2% before at least late 2019.

Figure 7: Euro area annual inflation and its main components, January 2007-October 2017.
Source: Eurostat

The actual unemployment rate is getting close to its structural level but the key missing element might be wages, which are barely rising despite the relatively rapid decline in unemployment over the past four years. It could be one of the reasons why the inflation struggles to keep up.

Figure 8: Actual and structural unemployment rate. Source: European Commission, Eurostat
Figure 9: Wages and inverted unemployment rate. Source: Thompson Reuters Datastream

All things considered, the slow rate of inflation and the risk of too much euro apreciation suggest that the ECB should not rush the normalization. The ECB decided not to put an end date to QE, thus keeping the program formally open-ended, with some obvious disagreements from northern creditors. Hence, if economic data unexpectedly worsen, the ECB could extend purchases again. Once the programme concludes, if ever, there will be a long period during which the ECB will reinvest the money from the bonds that expire, leaving the total size of the ECB’s balance sheet unchanged.

Figure 10: Euro Area 5 years after Draghi’ s “whatever it takes”. Source: Bloomberg


Figures 11 and 12: EUR/USD and European Bond Yields, Today. Retrieved from Bloomberg

Let’ s say that the net purchases continue until 2019: if so, the ECB’s balance sheet will not start to shrink before 2021. Thus the interest rates will remain substantially low in Europe for a long time, that is at least until the balance sheet starts to contract. The reason behind that, is that Europe is in a particularly bad shape, that is getting better, but is still weak, coming from a decade crisis. Finally, not all its members are responding similar to the stimulus, because of their structural differences.

No escape

There is another, unspoken reason, why the ECB continues to buy assets — if it were to stop, the eurozone crisis might return. Investors would have to assess whether Italy has the capacity to sustain its public sector debt with its fiscal policy alone, which is more than 130% of GDP. The country’ s bond yields are at elevated levels compared with most other eurozone countries and the prospect of the ECB slowering its QE has put upward pressure on the Italian bond yields. 19% out of the €1.4tn of government debt bought by the ECB since March 2015 has flowed in Italian bonds.

Figure 13: TARGET balances of participating National Central Banks, Historical data
(EUR billions)
Source: ECB
Figure 14: TARGET balances of participating National Central Banks, Last reference period
(EUR billions, September 2017)
Source: ECB

Since 2015 in particular the deficit of Italy and Spain in the Target 2*** system has increased, while the German surplus have grown. Peter Praet, a member of the ECB board, recently explained that the ECB, through its QE, does not buy government bonds directly, but each central bank of the eurozone buys their own sovereign bonds. Since most of bond purchases by the NCBs are done with foreign parties, the QE determines the Target 2 dynamics. Given that the prospects of Italian bonds have not been attractive****, Italian commercial banks, but also families and private funds, have been reducing their possession of government bonds, after Draghi’s “whatever it takes”, finally finding foreign buyers. Operating with an undervalued currency – which, in turn, has created huge external surpluses – the QE forced German banks to finance the surplus by moving German savings abroad, both within and outside the euro area (especially the US). With the crisis of over-indebted euro area governments and banks, the ECB came to the rescue through the huge provision of liquidity, hoping to prevent their collapse. In the course of this operation the German Bundesbank came to hold almost EUR 900 billion in credits on the Eurosystem under the Target 2 (Figures 12 and 13).

A removal of ECB support would mean that Italy could be forced into a bail-out programme if its borrowing costs rose to unsustainable levels, opening for a massive debt restructuring and another financial crisis. Large permanent imbalances create risks also for German tax-payers: if a country with a large Target2 debt leaves the euro, its NCB would be unlikely to repay its debt. The Bundesbank, as the main creditor, might seek reforms of Target2, at some point. There is still the possibility that the European Banking Authority considers an European Monetary Fund that would be able to to bail out Italy if necessary, as the new German coalition will push for. The danger with unsustainable financing arrangements is that they might end up to get corrected by a shock without due care.

Depending on its disrupted politics, the Eurozone might live forever in a state of constant liquidity injections, that in the end would be monetary flows from creditors to over-indebted countries and ECB may never be able to stop them. Because if it did, through disinflationary effects of a debt restructuring, it might cause another financial crisis, which as under its legal obligation to prevent. If the eurozone is lucky, the ECB’ s QE might end in 2019 without any debt defaults and sustaining a sufficiently high core inflation level in all countries. If not, the purchases might go on indefinitely, or at least until there is creditor’s willing to do so.

The ECB last week yet confirmed that they will never leave the markets alone. Any change in the outlook and they will intervene more, remaining in permanent intervention mode. Because this is what it takes.


  • *With the QE, commercial banks have found themselves with the additional money that Central Banks were using to purchase government debt but, given that the economy have been hit by recession, the interest rates have been so low and stock markets have been performing so well, commercial banks have been encouraged to use their money in speculative investments instead of traditional lending and to park their money in excess reserves for their sake of balance solidity. Indeed if the money injected in the system never makes it into the economy, it will not be inflationary.
  • **Across developed market economies this year, stronger economic growth and lower unemployment have failed to accelerate wage growth. The Phillips curve, which measures the responsiveness of wages to unemployment, is flat today by historical standards, prompting many investors to question whether wage inflation has been permanently subdued by structural factors such as automation and globalisation.
  • *** Target 2 is the system that regulates the trans-national payments between euro-countries  and their central banks, who are the main players, along with the larger banks.
  • ****Given the state of economic stagnation and a political trend in which can be hardly seen the next Italian government undertaking the needed structural reforms to raise long-term productivity.

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