ECB Decision & Transmission Mechanism

James Mee looks at the Quantitative Easing (QE) Question in Europe

The QE Response

In 2008, the Federal Reserve (Fed) enacted its first round of QE in order to stimulate markets and the economy.  Policy makers began by buying large quantities of short term debt, which in turn pushed investors into riskier (albeit not necessarily “risky”) assets, and thus asset values up.  This in turn led to a wealth effect which, aided by lower oil in the latter stages, kick-started the economy and started a 6-year bull market in risk assets.

The reason QE as a monetary policy tool worked in the US was that interest rates started off materially higher than they are today, it was unexpected, and capital (i.e. public bond and equity) markets were well used by American companies, enabling them to be the “transmission mechanism” through which the central bank could get money into the economic system.

European QE3?

Turning to Europe, Mario Draghi, head of the European Central Bank (ECB), has again reiterated that there is more they can do in terms of monetary policy in Europe; the ECB has “power, determination and willingness” to act.  His dovish tone combined with explicit reference to the March meeting as a potential point for further stimulus has been positively received by the market and led to its appreciation over the past two days.

Will further QE be beneficial to Europe?

QE appears to follow the rule of diminishing returns.  As successive rounds are initiated, they have less effect on government bond yields and corporate spreads (given that both are already low). It is also notable that in Europe we rely much less heavily on capital markets for our funding, preferring bank financing.  As such, it takes longer for the effect of QE via capital markets to reach the “real” economy.

Is further QE a waste of time?

No.  There are signs that this liquidity is reaching the real economy, albeit slowly, and the downward pressure it puts on the Euro is beneficial to European exporters and European-listed multinationals. Furthermore, from a psychological perspective it will be a good thing; indeed, Mr. Market* has already reacted positively to the hint of further policy action in March.

Is QE the Solution to all our problems?

No.  While QE has the potential to reinvigorate the market and stimulate the economy, in practice it cannot be the solution to the economic problem Europe finds itself in without serious structural reform.  Deprived of such reform, QE will only plaster over deep cracks that still linger within the region’s economy.

As at 21.01.16

*An imaginary investor devised by Benjamin Graham and introduced in his 1949 book "The Intelligent Investor".  In the book, Mr. Market is a hypothetical investor who is driven by panic, euphoria and apathy (on any given day), and approaches his investing as a reaction to his mood, rather than through fundamental (or technical) analysis.   

Source: Mr. Market Definition | Investopedia

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