The ECB may consider putting a big Q to the left of this. Photo by Hannelore Foster/Getty Images
Breaking News out of Frankfurt: The ECB held interest rates stable! Just kidding, they actually cut their rate on four-year loans. Oh and announced the full-scale quantitative easing (QE) program pundits have long salivated over, which we guess is bigger news. Now that QE is reality, we fully expect headlines will laud it for stimulating growth, fret its potential end, argue over whether it will cause hyperinflation, fear it isn’t big enough, and so on. All happened in the US, UK and Japan, and we have little reason to expect different in the eurozone. We also don’t expect QE’s impact to differ: The ECB’s interference with long-rates should keep the yield curve flat, discourage bank lending and slow growth. But, though negative, ECB QE is too widely discussed and too small to flip this bull into a bear.
First, the details. The ECB will buy €60 billion of sovereign, agency and private debt monthly from March through September 2016 (although officials indicated the end isn’t set in stone). The aim, as has been widely reported for months, is to add just over €1 trillion to the bank’s balance sheet, bringing it back up near 2012 levels. National central banks will do 80% of the buying to get around EU treaty restrictions on the ECB financing governments (not the aim, but a concern some raised). No Greek debt will be purchased until at least July—probably wise, considering Greece has asked to default on ECB-held debt. Like other QE doers, the ECB seeks to lower long-term interest rates to stimulate loan demand, increase lending and grease the eurozone economy’s wheels. The ECB theorizes this will boost inflation toward its 2% y/y target (it is presently -0.2%) and goose GDP by a few tenths of a percentage point.
However, there is little-to-no evidence QE actually does any of this. During US QE, loan and GDP growth were the slowest since WWII. Since talk of ending QE (and the actual wind-down) began, both accelerated. During Britain’s QE, GDP and lending wavered between growth and contraction. After the BoE stopped QE bond purchases in late 2012, growth popped. The BoJ has the world’s largest QE program relative to GDP, yet Japan is mired in its third recession since 2009, loan growth is anemic, and whatever inflation there is stems mostly from last April’s sales tax hike. Where, in this available evidence, is the concrete sign QE works?
QE violates age-old theory, too. Economists have long theorized adjusting the quantity of money influences growth and inflation. Boost it, and more capital is available to finance expansion. Shrink it, and there is less. Many presume QE boosts the quantity of money—but it doesn’t. QE increases the quantity of bank reserves, which underpin lending in a fractional reserve banking system. But the quantity of money increases only if banks lend, which they usually do when profits reward them for risking loss.
QE shrinks profits, which are often determined by the spread between short-term and long-term interest rates—the yield curve spread. Banks borrow short-term (think deposits or overnight borrowing from one another) and transform this funding into longer-term loans (business, auto, home). The gap between what they pay for funds and receive on loans is profit. When central banks meddle with long-term rates, keeping them low, it reduces profits and adds an air of uncertainty that lingers until the central bank backs off. Banks prefer profitable loans, so reducing their margins likely doesn’t yield a big boost.
ECB QE is smaller than America’s, only $68.4 billion monthly[i] versus the Fed’s $85 billion, so it probably isn’t a bigger drag. However, it hits more businesses, as the Continent has much less developed capital markets than the US or UK. Bank lending comprises 85% of eurozone non-financial businesses’ funding. By contrast, more than of half US nonfinancial firms’ funding comes from capital markets.
So why do so many think QE is so stimulative? We have a theory: They see the coincidence of QE and bull markets as causal. Japan’s first QE foray sort of coincided with 2002 – 2007 bull market. The US bull market began in March 2009, five months after the Fed announced QE. Since 2009, the UK and US have led developed-world growth, and both had big QE programs! Voila, correlation!
But … this alleged correlation has holes. Japan’s 2001 – 2006 QE began in March 2001, nearly two years before the global bull began. QE ended in March 2006—roughly a year and half before the bull died. (Japan also lagged during most of it, which you might not expect if this was so stimulative.) US QE was announced in November 2008 and launched in January, but the bear market didn’t end until March 2009. Some claim this is because QE was expanded then. Yet this ignores the much more likely culprit, FAS 157’s (the market-to-market accounting rule) suspension. That rule’s late-2007 implementation is near the bull’s peak, too, so it correlates to the start and end. It also better explains causation. Exaggerated accounting writedowns at Financials played a key role in the bear. And yes, the US and UK have led developed world growth, but as mentioned, both nations accelerated markedly after QE ended (and saw broad M4 money supply shrink for long stretches during QE).
US, UK and Japanese QE were economic headwinds and we believe eurozone QE will likely follow suit. Yet QE hasn’t yet zapped the bull market, and we doubt it will now. For one, this announcement was widely expected and watched, so it lacks surprise power. Eurozone sovereign bond markets have long been pricing in ECB buying—one reason German maturities as long as five years are in negative territory. But hopes for a jump in eurozone growth because of QE are probably misplaced.
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[i] Currency conversion based on 1/22/2015 USD / euro exchange rate of 1.14.