It's not so QEasy

September 15, 2019

 

 

On September 12 the European Central Bank announced the beginning of a new wave of Quantitative Easing (QE). The term that has been in the news for a while now, with quite a few misunderstandings attached and a general aura of misinformation surrounding it - but what is it, really?

 

In the following paragraphs we’ll go through the treaties that rule the ECB and how they impact its policies - namely, QE.

 

The term Quantitative Easing is relatively new in the economic narrative, appearing for the first time in the 1990s with an operation of the Bank of Japan, although at the time it did not attract anywhere close to the attention it received from 2015 onwards, when the ECB launched its own QE program. In its European variant, it is constituted by two different components: an intervention on interest rates, usually bringing them to lower levels, and the more traditional Open Market Operations (OMO), with which central banks (CBs) interact with the markets by buying assets, inflating their balance sheets and increasing the monetary base. These assets can be both private and public (for normal CBs), can be acquired on either the primary or the secondary market (again, in the general case), and are generally obligations or debt instruments. So, QE has been around for a while, and the intensive use of the new name can be mostly attributed to the need of making it more acceptable for some members of the Governing Council of the ECB. The most notable difference is that the OMOs in the ECB Quantitative Easing only be executed through the secondary market.

 

The articles ruling the possibility for Governments and the ECB of buying assets from the markets are respectively n. 125 and 123 of the Treaty on the Functioning of the European Union. They can be resumed in a simple concept: Sovereign Bonds can only be bought on the secondary market, i.e. only when a private investor has deemed the security to be fairly priced. This means that QE can be used to invest in National Bonds, but only when they are sustainable (if they are not sustainable another ECB program kicks in, the OMT). 

 

The purchase of such assets is bound to raise their price and lower the yield, thus helping the governments lower their cost of financing, but this is in no way the main objective of QE.

 

Battle hard won

When it was first introduced, QE was the field of a strenuously fought battle between two different ideologies in the ECB Governing Council, which was ultimately won by President Draghi. While the opponents were seeing QE as a de facto breach of Art. 123, the ratio brought forward by the winning majority was that the only objective of the ECB was to keep the inflation level in the Euro Area close but below 2%. This required a conventional monetary policy operation, aka what we now know as QE (plus an action on interest rates, but that is a topic for another time). The success of the program in general is questionable, as through the years the inflation level has just once approached the desired level, only to fall back down a few months later with the new trade-war-induced export crisis. 

 

In the announcement released on Thursday, two points were made: first, the purchase of €20 billion of assets per month, and second, a further lowering of interest rates bringing them even closer to zero. While the first may seem too modest in dimension to have any real impact (although it has already had the usual “unwanted” effect of lowering yield spreads), the second gives a clearer glimpse of the intention of the ECB, at least as long as the slowdown in the European economies (and the subsequent slumber of prices, followed by low inflation) lasts.

 

To sum up, QE:

  • Is not purpose-made to help anyone, but wants to impact inflation levels

  • Does not mean a free pass on sovereign debt, as the purchases take place on the secondary market only

  • Has inflated the ECB balance sheet, and a further large increase in the masses connected to the program may require exposure to riskier assets (a critique often brought forth by German school economists)


However, in the years it has been active, it has had an “unwanted” fundamental role in supporting Euro Area economies and governments. 

 

We will miss you, Mister Draghi.


 

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