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Eurozone’s Woes and a Look Back at QE


In an effort to keep low inflation from damaging the Eurozone’s stagnant economy, the European Central Bank (ECB) president, Mario Draghi, announced new stimulus plans at the central bank’s governing council meeting on September 4th.

The Eurozone which consists of the 18 European Union member states that share the euro as their national currency, is currently facing economic challenges. Amid extensive evidence of economic slow-down were the latest inflation estimates by Eurostat, the European Union’s statistics agency. Inflation in the Eurozone fell from 0.4% in July to 0.3% in August, hovering close to deflation and far below the 2% target. Deflation is dangerous because it leads to falling profits, closing of factories and ultimately to high unemployment. The threat of deflation prompted Draghi to take drastic actions. Starting October of this year, the ECB will begin buying asset-backed securities: packages of home loans, business loans and credit card debt which banks bundle to sell to investors. Details on this program will be announced in October but the goal is to fuel economic activity through easily available credit, while generating inflation. Moreover, the ECB cut its main refinancing rate, the rate at which the central bank issues short-term loans to banks, to 0.05 % from 0.15%. The central bank hopes this will prompt a drop in interest rates and make loans cheaper for consumers. It also deepened the negative deposit rate, the fee it imposes on banks to store money at the ECB, to – 0.2% from -0.1%. This implies that banks will not deposit more than necessary with the ECB since this comes at a cost and instead they will lend the money to borrowers.

Markets rallied on the ECB when Draghi made the announcement on September 4th with the Stoxx Europe 600 up 1.1%, and the FTSE 100 rising 0.1%, closing in at an all-time high. The euro fell 1.6 % against the US dollar. Economists welcomed the news as a sign that the ECB is trying to prevent the Eurozone from the threat of deflation. Most important, was the overall market sentiment that the ECB shows concern on the part of policy makers. This comes at a difficult time for the Eurozone.

Unemployment in July remained constant at 11.5%. Moreover, there were great discrepancies among the 18 members of the Eurozone. While the unemployment rate in Germany and Austria was 4.9%, Spain’s hovered at 24.5%. The numbers portray a grim picture with over 18.4 million people unemployed in the Eurozone and almost 25 million jobless in the wider European Union, where unemployment remained unchanged at 10.2% in July.

Eurozone GDP in the second quarter remained unchanged from the first quarter, standing currently at 0.2%. Italy fell back into recession, French GDP was flat and even Germany, long Europe’s economic champion, saw an unexpected fall in output. In contrast, in the United States, real GDP climbed at a seasonally adjusted annual rate of 4% in the second quarter.

The Eurozone Manufacturing Purchasing Managers Index (PMI), which gauges business conditions in the manufacturing sector, dropped to 52.8 in August, a two-month low, from 53.8 in July. The manufacturing sector represents approximately a quarter of total Eurozone GDP, and the PMI is a significant indicator of the general health of the economy. The index numbers were in line with analysts’ estimation of slow GDP growth for the third quarter which is “unlikely to stimulate turnaround in the labour market”, according to Markit, a financial think-tank.

While the September 4th announcement is encouraging, the ECB has resisted calls to implement full-on quantitative easing (QE) similar to what the Fed had done. Draghi lacks political support, especially from Germany’s influential Bundesbank and the ECB is prohibited by European Union law from using quantitative easing, which is seen as a measure of last resort. However, it is worthwhile to understand what QE is and what has happened in the US economy as a result of its implementation.

The U.S. Federal Reserve has used QE to boost the U.S. economy in recent years. Historically, the Fed’s main tool for spurring growth has been to engage in Open Market Operations (OMO) by lowering short-term interest rates. QE involves the Fed purchasing bonds with new money, when the interest rate can no longer be lowered. Quantitative easing is a complex subject that has stirred mixed opinions among experts. In a nutshell, quantitative easing occurs when the central bank of a country purchases securities, such as bonds, in order to increase the national money supply. The belief is that expanding the central bank’s balance sheet will boost the economy. In order to help stimulate economic growth, the central bank issues new money (essentially from nothing) that is subsequently used to buy financial assets from other banks in the country. These banks can then loan the new money received to borrowers. Ideally, as it becomes easier to get a loan from a bank, consumers and businesses would spend and borrow more money, which in turn would stimulate the economy. When consumers and businesses have easier access to loans there is a greater demand for goods and services and thus more jobs. While this is the textbook explanation, it must be acknowledged that quantitative easing is not an exact process. The U.S. has had three iterations: QE1, QE2 and QE3. In order to comprehensively analyze the impact of QE it is important to look at the timeline and examine each round of easing.

QE1 was initiated in November 2008, three months after the Lehman Brothers collapse. This round lasted for 17 months, the longest so far. Each month the Fed purchased $100 billion worth of mortgage backed securities and bank debt (amounting to $1.7 trillion in total). Fed Chairman at the time, Ben Bernanke, stressed that QE1 was more atypical, being in fact “credit easing” and it focused on the asset side of the balance sheet. Most experts agree that as a result of QE1, the Fed took the most of the mortgage-backed securities market onto its balance sheet in order to prevent an economic disaster. From November 2008 to April 2010, the adjusted monetary base grew from $1,265 billion to $2,076 billion, an increase of 64%. The goal was to inject liquidity into the financial system to stimulate the economy, but the focus was to primarily make available additional bank reserves rather than lowering interest rates. The economy appeared to have improved from supported credit markets and liquidity provided to the private sector. QE1 ended when the Fed saw signs of economic improvement in early 2010. While the banks exchanged their toxic securities for cash from the Fed, they had no incentive or obligation to lend it out to borrowers.

The signs of economic improvement however were considered to be premature at best. In fact, consumer confidence was down and businesses where reluctant to hire since demand, expressed by consumption expenditure, was so low. Inflation in the US at the time was dangerously low and the Fed did not want the US economy to experience Japan-in-the-90s style deflation. As a result, the Fed announced in August 2010, at the beginning of the program, that it would be purchasing $600 billion in Treasury bonds. The second round of easing, known as QE2, aimed to support economic activity in the US economy. QE2 lasted 7 months from November 2010 to June 2011. This time, the Fed purchased US Treasury bonds, rather than mortgage-backed securities by spending $85 billion each month. When the Fed made such purchases of Treasuries, the result was an increase in demand for these securities. There is an inverse relationship between Treasury prices and yields (interest rates). Increased demand leads to higher prices for the securities and thus lower interest rates. As a result, the cost to businesses for financing investments, expressed by the interest rate, decreases and this would boost economic activity by creating new jobs and lowering the unemployment rate. However, the reserve deposits increased in the private sector. While the reserves could have been lent out, the reality of the time was that the money sat idly in bank vaults. It was naive to assume that the mere creation of reserves has a major impact on lending in the banking system. Fed’s QE2 raised inflation expectations, increased business credit and raised asset prices, but the economy cooled during QE2. Toward the end, asset prices and bond yields started to decrease as inflation expectations plummeted. During the seven-month program, the monetary base expanded to $2,625 billion, a 26% increase.

Finally, QE3 began a year after QE2, in September 2012. The Fed announced that this time it would be purchasing mortgage-backed securities and US Treasuries indefinitely to the tune of $40 billion per month initially, upping the amount in December 2012 to $85 billion. In addition to QE3, a program called “Operation Twist” began in September 2011. This was the Fed’s plan to sell short-term treasuries they had and use the money to buy securities with a longer term. The idea behind “Operation Twist” was that by flooding the market with short-term Treasuries, short term interest rates would rise. Conversely, by buying up longer term securities they would do the opposite, long-term interest rates would fall. The “twist” came from the invisible twist in the yield curve that was expected to result and it appeared to have worked despite prominent scepticism. In June 2012, the yield on the 10-year treasuries fell to 200-year lows prompting a recovery in the housing market and bank lending. Experts agree that QE3, which was implemented in September 2012, did produce results. The low US dollar meant that US stocks became cheaper for foreign investors, thus encouraging investment. Exports increased during the period when QE3 was active for the same reason. In December 2013 the Fed decided to taper (i.e. decrease) its monthly purchases of Treasury and mortgage-backed securities to $75 billion from $85 billion and it has continued the taper in 2014. Bernanke’s decision reflected the conclusion of the Fed that the program had served its purpose. He also suggested that QE3 will finish toward the end of 2014.

Bernanke stepped down as chair of the Fed in January 2014 and was succeed by Janet Yellen. In his final public appearance he defended the Fed’s attempts to revive the economy through quantitative easing a method aimed at protecting Main Street. He dismissed the criticism that QE was inflationary and economic evidence indicates that he was right.

What were some consequences of quantitative easing? QE did in fact remove the toxic subprime mortgages from banks’ balance sheets and restored trust in banking operations. It also helped stabilize the US economy, providing the confidence to pull out of the recession. Moreover, it kept interest rates low enough to revive the housing market and it did stimulate economic growth, although likely not as much as the Fed had wanted. Bernanke did in fact express regret that he was leaving with the unemployment rate at 7% and not lower. Much of the money from the asset purchases went into the stock market, helping to sustain the five-year bull run; in March 2009, the S&P 500 hit 676 points. Today the S&P 500 stands at 1,992.

What remains to be seen is if the ECB is on its way to implement a QE program of its own. Some experts say that having already made the September 4th announcement, ECB policymakers will need to wait some time to gauge the effect of its policies: rates near zero, cheap long-term loans for banks and purchases of securitised debt, before taking on a further course of action. Pursing full-scale quantitative easing will no-doubt bring about political obstacles. At the Federal Reserve conference in Jackson Hole, which took place in August, Draghi called on the much needed structural reforms in the Eurozone: “No amount of fiscal or monetary accommodation, however, can compensate for the necessary structural reforms in the euro area.” This idea resonates with one that Bernanke himself had made; that monetary policy is “not a panacea” which implied that there is only so much that the Fed can do to trigger growth in a struggling economy. The ECB will give new details in October on its asset-buying program, which experts now call QE-lite, but only time will tell whether the ECB’s new actions announced on September 4th will be enough to fix the prominent problems of the Eurozone.






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