What are the challenges of the end of Quantitative Easing ?
- Paris, France
Laurent Quignon, Head of banking economics at BNP Paribas is answering to our questions.
Could you give us a quick definition of Quantitative Easing?
Quantitative easing (QE) involves a central bank buying up medium and long-term public and private debt in massive amounts.
We can distinguish between two transmission channels.
The first channel is direct and relates purely to accounting. When European Central Banks buy securities from commercial banks or their clients, it grows the reserves held by these banks with the central bank. The resulting abundance of central money helps to lower rates on interbank and money markets. In addition to commercial bank reserves, the European Central Bank’s (ECB) purchase of securities from non-bank resident agents also swells the liquid deposits made by these agents with commercial banks, which is a major component of money supply.
The second effect is less direct but just as important. The decline in bond market yields inherent to the ECB’s buy-ups lowers the costs of financing and stimulates demand. The resumption of bank financing helps support growth and the money supply, by virtue of the adage that “loans create deposits”.
What is the role of central banks? Why do they intervene?
Monetary policy aims primarily to maintain inflation near a target rate of 2% in the eurozone and the United States. Central banks traditionally implement a rate policy, but as their room for manoeuvre becomes limited, they are forced to adopt unconventional measures to maintain an efficient monetary policy. In the eurozone, this includes more long-term measures (LTRO (Long Term Refinancing Operations) and TLTRO (Targeted Longer-Term Refinancing Operations) between December 2011 and March 2017), the negative deposit facility rate since June 2011 or quantitative easing.
What impact does Quantitative Easing have on the real economy?
In practical terms, after declining for three years in a row, outstanding bank loans in the eurozone’s non-financial private sector have taken a positive turn since May 2015 and continue to gain momentum today (+2.4% in September 2017). At the same time, money supply has grown at a dynamic but relatively stable rate (between 4% and 5% per annum) since 2015. Aside from the indirect effects of lower rates, the larger money supply could have resulted from security sell-offs by non-bank resident agents to the ECB. Nonetheless, our calculations suggest that commercial banks are the main securities sellers thus increasing their reserves with the central bank, followed by the rest of the world.
Why are we heading towards the end of Quantitative Easing in the United States?
The Federal Reserve has led three successive asset buy-up programs since November 2008. These actions raised the Fed holding of securities from under 500 billion dollars at the end of 2008 to more than 4,200 billion dollars at the end of 2014. Securities purchased through these programs consisted largely of treasury bonds and mortgage-backed securities (MBS) guaranteed by the agencies. In December 2013, the Fed announced it would taper off its asset purchases from January 2014 onwards and suggested a faster reduction if the job market improved and inflation neared the 2% target. That was done on a progressive basis and as a result the asset purchase program was concluded in October 2014. In October 2017, as it had announced in September, the Fed took a crucial step by initiating the process to reduce its balance sheet. It will do so by reducing its reinvestment of payments made by issuers of securities it holds.
Why did the Fed announce the end of Quantitative Easing? Has this measure already come into effect? What is the economic context behind this decision?
This decision is driven by the Fed’s current confidence in the US economy, which is now deemed to be robust enough to make do without the crutch of QE. As the Fed took this decision, underlying inflation recorded its highest month of growth in August (+0.25%, with the annual rise stable at 1.7%). Global inflation rose to 1.9%, a level that meets the 2% target. The Fed underlined that inflation may increase temporarily due to spikes in energy prices following hurricanes, but will remain stable over the medium term at or around this target rate. In September, global inflation rose slightly (+2.2% over one year) due to the effects of energy prices, with its underlying component prolonging this trend (+1.7%). At the same time, the US economy has grown since the second quarter at an annual pace of 3% and the job outlook continues to improve. Unemployment has fallen sharply since the start of the year (4.2% in September compared with 4.7% in January) and reached its lowest rate in 17 years in October (4.1%).
What is the situation in Europe?
If we exclude the covered bond and ABS purchase programs started in 2009 and 2014, which covered much more modest sums, we can say that QE truly started in March 2015, when the public sector purchase program began. This program was supplemented by a corporate sector purchase program in June 2016. Public and private sector purchases, originally set at EUR 60 billion per month, had been increased to 80 billion per month from April 2016, and have been reduced again to 60 billion from April 2017.
On November 3, 2017, the ECB’s securities holdings acquired through this program reached 2.1 trillion euros, largely in the form of securities issued by the public sector (1.8 trillion). The ECB announced on October 28 that it would further reduce its monthly purchases to 30 billion starting in January 2018. It plans to continue the program at least through September 2018, though it may extend the period or raise its total monthly purchases again if necessary. So technically the ECB has entered the tapering phase, which means its balance sheet will grow at a slower pace in the coming months. Consequently, quantitative easing is not yet over as it would result in a reduction – or a normalization - of the balance sheet of the ECB.
Does the end of Quantitative Easing mean a return to higher interest and inflation rates?
Like other measures designed to relax monetary policy, quantitative easing aims to support the real economy when necessary to keep inflation below a critical level, but also to support job growth. The actual end of quantitative easing is still a long way off, because the ECB is still reducing its monthly asset purchases at an extremely gradual rate. Looking further ahead (2019, 2020), the ECB will likely move to normalize its balance sheet, which should lead to a long-term rise in rates driven by market anticipation. In this way, in the United States, 10 year T-Note yields have trended down more than 30 points since the start of September, the month in which the Fed announced its plan to gradually shrink its balance sheet. Similar to other accommodating monetary policy measures, QE aims to bring slack inflation back to a target level. If inflation gets back to around 2%, it will be due (at least in part) to QE, making it a cause and not a consequence of the end of QE. In October 2017, annual inflation fell slightly in the eurozone (+1.4% compared with +1.5% in September). Similarly, normalizing the monetary policy will first require growth and jobs to remain on the right track.
What risks and opportunities do these impacts pose?
Mario Draghi has expressed his intention to keep base interest rates low over a long period following the end of Quantitative Easing. Why?
It makes sense because unconventional measures complement the drop in interest rates, which is still a conventional measure. For transparency’s sake, it is best to stop asset purchases before raising the base interest rates. That is the path chosen by the Fed: the first interest rate hike came in December 2015, more than a year after its last asset purchases in the context of QE. The staggered economic situations within different eurozone countries presents a major challenge for the ECB. Rate hikes must be sufficient to prevent tension within dynamic economies marked by low unemployment (Germany, Austria, the Netherlands, and several Eastern European countries), while also preventing bubbles. On the other hand, it cannot happen so fast that it halts the economic turnaround in other countries (Italy, Belgium or even Spain, where unemployment remains high due to sluggish growth).
Even if credit volumes benefited from QE, credit expansion has not compensated for the effect of shrinking margins on bank revenue, which is particularly visible in retail bank activities. A gradual rise in interest rates would help to prop up bank revenues.
Why should this measure be adopted on a gradual basis?
Considering the massive volumes of assets purchased by the ECB, pulling out of QE too quickly would destabilize the bond market and lead to a brutal spike in long-term interest rates. That could set the stage for a negative wealth effect among economic agents holding bond portfolios (notably insurance companies and banks). From the banks’ perspective, extending low interest rates is not preferable because it would reduce the long-term yield of portfolios. And yet, a hasty interest rate hike risks driving up the cost of banking resources faster than the return on banking assets (as the former have a shorter duration due to the maturity transformation carried out by banks), notably amplified by client preference for products paying market rates of interest.
Shrinking bank margins caused by withdrawing from QE too rapidly and the tensions on interest rates could have negative effects on the financing of the real economy, which is an obvious pitfall to avoid. The central bank also has to take care not to destabilize markets.
In the United States, the Dow Jones fell by more than 4% in the three days following the Fed’s announcement in May 2013 that it would taper off its asset purchases in the month of September. In September 2013, due to last economic developments, the Fed reported its tapering . As announced in December 2013, its tapering began in January 2014.
In light of this experience, the ECB will continue to tread softly in its actions and keep a communication strategy (forward guidance) which allows observers to steer expectations about future policy