Quantitative easing: ECB has a difficult choice

The European Central Bank shows that there are two good reasons to stop a course of medicine: if it has worked, or, as is the case with quantitative easing (QE), when it isn’t working any more.
Next year may be the best chance of a successful taper the ECB can expect to get.
German 10-year government bond yields soared on Thursday, rising by more than a third to 0.36 percent after a Reuters story drawing on ECB sources said the central bank may soon send a formal signal that its QE program will eventually end.
Other tactics are also possible, according to the story, including extending QE at a lower level or not specifying the monthly purchase amount, thus giving the ECB freedom to calibrate asset buys to current conditions.
While one source in the ECB drew a distinction between a “signal” and “tapering” it is obvious that the former has no point if it isn’t a precursor to the latter.
Given that it is obvious — after all even stars eventually consume themselves — that the ECB can’t carry on buying bonds and other assets forever, the strength of the market reaction was striking.
It is important though not to conflate the power quantitative easing has on financial markets with its power and efficacy in the real economy.
Making a bund price chart dance on a screen is a different matter to making a banker extend a loan to a real borrower.
More to the point, it is a far different matter to convincing that borrower that the loan is a good idea in the first place.
“While we do not doubt the positive impact that QE has had on the level of interest rates, fragmentation and the exchange rate, we see no convincing evidence of a re-leveraging of corporates in the euro area driven by the will to invest and doubt we will see a strong expansion in the immediate future,” Anatoli Annenkov of Societe Generale wrote in a note to clients.
“Given these conditions, fiscal policy has likely a better chance of boosting demand and inflation expectations,” he said.
Borrowers in the euro zone are hesitant to commit to investment for a host of good reasons: the slow pace of structural reform, demographics, and, not least, their own high levels of debt.
In addition, deflation risk in the euro zone has diminished, and there can be debate about the role QE played in that, but inflation looks highly likely to stay below the ECB’s target of nearly 2 percent for several years.
So, in essence, the ECB has a difficult choice; have its credibility dented by withdrawing QE before it can declare victory or watch it being worn away slowly over time as inflation fails to respond.
If you can’t taper with the economic conditions you want you had better taper with the economic conditions you have. The ECB may allow itself more leeway to purchase a higher percentage of bonds issued, but this is a finite process.
An October paper from Andrew Haldane and others at the Bank of England concluded that QE is most effective when financial markets are not functioning correctly, usually due to illiquidity. 
Current euro zone markets do not meet that test.
Ironically, the ECB may have caught a bit of a break with the election of Donald Trump as US president. 
Expectations that Trump will run a reflationary, or inflationary, fiscal policy have sent US bond yields higher in anticipation of faster tightening from the US Federal Reserve. 
The Federal Reserve is almost universally expected to raise interest rates this month, and some now see two or three more 25-basis-point increases next year. 
This has helped the dollar strengthen against the euro and, if inflation expectations in the US continue to rise, will give a useful cover for an ECB wanting to step back from bond purchases.
Sunday’s Italian vote on a proposal to centralize power and streamline the representative branch is an important variable. Polls say voters will reject the measure, an outcome Prime Minister Matteo Renzi has said will prompt him to step down. That, in turn may open the way for gains by euroskeptic parties, either in a new election or as frustration builds while a provisional or technocratic government tinkers.
While it will be hard to signal a taper if Italy will have a first-quarter general election, the same logic applies here as it does to the economy. If QE will go on until Italy is “fixed,” QE will go on forever.
ECB asset buying has been helpful, but the benefits have diminished and next year looks as good a time to step back as we can expect. 

Source: Arab News