Earlier this week, I participated in an economics panel at the Principal Global Investors Summit Series held in Des Moines, Iowa. There was a question posed that bears repeating. A client asked what the impetus would be for the ECB to engage in quantitative easing, or QE, as has been seen from the Federal Reserve and other central banks.
The key to answering this question is Germany and its central bank, the Bundesbank. Given Germany’s scarring experience with hyperinflation in the 1920s, the Bundesbank’s sole target was to keep inflation under control. Nicknamed “The Bank that Ruled Europe” because of its size and relative importance, the Bundesbank was the model on which the ECB was built. It essentially dictated the newly formed ECB’s monetary policy set-up, which is why the ECB has such strict inflation targets and now stands out as one of, if not the, most hawkish of the world’s central banks. The ECB’s inflation target, it’s unfortunate to say, I think is probably one of the reasons that Europe is in the trouble it is.
In this crisis, although the Eurozone is in recession, inflation has remained resolutely above 2% as a result of higher oil prices and tax hikes. Yet, unlike the UK, which is also in recession and, at times, has had inflation more than double the 2% target, the ECB has refused to cut interest rates below 0.75% nor – nor has it introduced quantitative easing. In my opinion, the ECB should have enacted QE a long time ago. They should not be sterilizing their asset purchases. And while we have seen the ECB becoming a bit more dovish, it is still essentially a proxy for the Bundesbank. And unfortunately I don’t think that’s going to change.
Even in its design, the ECB’s inflation target courts controversy. The ECB has an asymmetric inflation target of “below, but close to, 2% over the medium term.” This means that the ECB will ease monetary policy when it believes that inflation will exceed 2% in the medium term. But when will it cut interest rates? In the United States, the Federal Reserve’s dual mandate indicates that it will ease policy when expected inflation falls below 2% and/or employment is below full employment. In Canada and the United Kingdom, where the central banks have a symmetric inflation target of “2%, plus or minus 1%,” policy rates will be cut when expected inflation falls below 2%. In the Eurozone, however, the ECB’s asymmetric inflation target – taken literally and followed strictly – applies no pressure to cut interest rates until inflation is expected to turn negative! Arguably then, its inflation target encourages the occurrence of deflation…Japan anyone?
What’s more, the ECB has to target average euro-area inflation, where member countries do not have equal weighting. Their weights are defined by their share of the Eurozone’s overall private final consumption expenditure. So when the ECB is making decisions, it must place more weight on the inflation outlook for countries like Germany and France than for smaller ones like Portugal and Ireland. As Germany has the greatest weighting, it essentially dictates ECB monetary policy.
What this means it that, while I think that Europe desperately needs QE, the only time the ECB is likely to do that is when Germany is at risk of deflation, bringing down the average euro-area inflation rate. Essentially, Europe won’t get any medicine until Germany gets sick. And I think that’s a long way off.
What’s more, even if the ECB did decide to introduce quantitative easing, they would have to structure it such that it used some form of GDP weighting. As Germany has the greatest weighting in the Eurozone, it would make up the lion’s share of bond purchases. That means the ECB would buy more Bunds and fewer Portuguese bonds…fewer Spanish bonds. So ultimately with QE, the ECB would be helping the one country that needs it the least – Germany. And while that’s probably fine for Germany, it doesn’t really help out the other countries that urgently need the assistance.
So I think the framework of the ECB is a very difficult one – it doesn’t mean the ECB is at fault – but it’s a very difficult framework to help out the European economy when it desperately needs it.