Quantitative Easing. An evaluation of its effectiveness for the European Central Bank


Essay, 2016
8 Pages, Grade: 78%

Excerpt

Contents

1. Quantitative Easing and its transmission mechanism
1.1. Policy Signalling
1.2. Portfolio rebalancing

2. Rationale and effectiveness of QE

References

“The primary objective of the ESCB is the maintenance of price stability” (Maastricht Treaty, article 105).

In March 2015, the ECB has introduced its first Quantitative Easing program (QE), “Public Sector Purchase Program” (PSPP), entailing €60 billion worth of monthly purchases of private and public sector securities with a maturity of 2 to 30 years until at least September 2016 in order to maintain its primary objective of price stability. In the following, this analysis will define QE and its transmission mechanism, as well as the effectiveness of QE and if it was necessary of the ECB to implement such an unconventional monetary policy.

1. Quantitative Easing and its transmission mechanism

QE is an unconventional monetary policy in which a central bank purchases public and private securities from the market in order to lower interest rates and increase the money supply resulting in a boost in nominal spending (Claeys, Leandro, Mandra, 2015).

QE policy is expected to influence economic activity through several transmission channels, affecting asset prices and bank lending and leading to changes in wealth and borrowing costs in terms of spending and the inflation rate. Valiante (2015) divides potential transmission mechanisms into two timeframes ex-ante and ex-post. Ex-ante mechanisms have a bearing on expectations concerning the future macroeconomic environment prior to QE implementation, namely policy signalling and confidence. Meanwhile, the latter includes channels affecting the actual availability of assets and the subsequent interaction of supply and demand, leading to alterations in investors’ portfolios and liquidity, as well as bank lending.

1.1. Policy Signalling

The strong QE transmission mechanism policy signalling of Central Banks has its power in the ability to influence interest rates and asset prices before actually undertaking large-scale asset purchases. Announcements and forward guidance of QE act as a signal to agents that the Central Bank will commit to keep policy rates low for a certain period of time, thus displaying determination to meet inflation objectives. This reduces term premia associated with uncertainty of holding long-term assets and therefore flattens the yield curve (Valiante, 2015).

1.2. Portfolio rebalancing

The purchase of long-term assets directly affects their price, including subsequent effects on other asset prices. Gagnon et al. (2010) exhibit that the removal of assets with a high duration from markets causes less duration risk to be held by market participants in aggregate, which in turn lowers the premium to hold such assets. Imperfect substitutability between money and financial assets enables an asset price effect due to relative demand and supply changes. As holdings of long-term risk-free assets decrease, there is a rise in money holdings of banks or private investors (Butt et al., 2014). Increased money holdings results in being traded for higher-yielding, riskier assets despite the fact that their purchases were not targeted by the Central Bank. When investors move away from low yielding government debt towards riskier assets such as the stock market, a wealth effect is created, thus, improving consumer and business confidence resulting in increased spending activities (shift of the demand curve).

2. Rationale and effectiveness of QE

Due to the Financial Crisis of 2008 and the Sovereign Debt Crisis in 2010, the ECB and other Central Banks sought to respond with aggressive monetary policy in order to prevent deflation and stimulate aggregate demand to maintain the primary objective of price stability. However, since nominal interest rates were already historically low, there was an increased likelihood of nominal interest rate policy being constrained by the Zero Lower Bound (Bernanke, 2004).

Figure 1: ECB’s rate corridor

Abbildung in dieser Leseprobe nicht enthalten

Figure 1 (Valiante, 2015, pp.4) indicates that the rate corridor has been significantly decreased after its peak of the sovereign debt crisis in 2011 due to lowering the deposit rate to a negative value of -0.2% and the marginal lending rate to 0.3%, reaching its respective lower bound (Fawley & Neely, 2013). Since the liquidity trap suggests that market participants prefer to hold cash reserves in the existence of negative deposit rates, short-term policy rates at the zero lower bound were not able to influence long-term rates anymore.

Figure 2: EU Household Credit Growth

Abbildung in dieser Leseprobe nicht enthalten

Moreover, as displayed by Figure 2 (Taborda, 2016), the credit growth rate have simultaneously decreased before the launch of the PSPP implying that the cheap financing was not transmitted to EU households in the form of loans, as the banks were about to restructure and refinance their balance sheet. This shows also the unsuccessfulness of all other possible tools in terms of policy rate adjustments and unconventional monetary policies in order to provide incentives to revive interbank activity, push liquidity out in economy and enable better conditions for economic growth. According to Valiante (2015), this is key reason for the necessity to implement QE and means that large-scale asset purchases are indeed a logical consequence to affect interest rates and asset allocation. Furthermore, with respect to Sheets (2012), Taylor rule predictions advocated lower policy rates than those achieved by Central Banks at the effective Zero Lower Bound.

Figure 3: EU inflation rate

Abbildung in dieser Leseprobe nicht enthalten

Considering the pattern of the inflation rate in Figure 3 (Taborda, 2016), there is a clear hike and structural change around the QE announcement in January 2015, which could be explained by Valiante (2015), who states that the EAGB yields decreased by about 2% mainly through the policy signalling channel at this time. Although the market was surprised by the announcement and the launch of PSPP (0.5%), the forward guidance process of the ECB contributed the major part of the signalling effect (1.5%).

However, after the increase a moderate development occurs in the inflation rate, not in favour of the current effectiveness of the QE program.

Figure 4 (Taborda, 2016) illustrates that unemployment rate has reached its peak in 2013 resulting in the aftermath of the Financial Crisis in 2008. With regard to the trend, previous monetary stimulus did not stop the economy from slowing down, which supports the necessity of QE as a last possibility.

After the launch of the ECBs QE program, there is observed a clear downwards trend indicating an increase in aggregate demand and economic activity. However, this could have also been due to the recovery of the general world economy not supporting the effectiveness of the QE program.

Figure 4:EU Unemployment Rate

Abbildung in dieser Leseprobe nicht enthalten

In general, a flattening of the yield curve across Euro-area is evidence of the big portfolio effect induced by the ECB’s asset purchase programmes. Investors flocked to riskier assets, in anticipation of the program (Valiente, 2015: Stoxx 600 rose about 19.8% from March 1, 2014 to April 30, 2015). However, the stock-market effect could possibly be due to the big depreciation in the euro boosting individual equity prices. On balance, this fall in the euro is evidence of investors flooding out of the European market, due to the prospect of low yields, and entering ones with higher expected returns such as the United States.

Moreover, a common rationale to launch extremely accommodative monetary policies is the competitive depreciating of the exchange rate in order to gain trade advantage over the countries, referred as “currency wars” (Picardo, 2015). Since all the main central banks such as the BoE, BoJ, and the Fed implemented all large-scale asset purchase programs before the ECB, the monetary authority has been forced to implement Quantitative Easing due to the impact on the euro's exchange rate.

Between 2012 and March 2014 the euro was valued by 9.9% in nominal effective terms, implying with respect to the economy theory, that a strong euro affects the region's competitiveness by making domestic exports more expensive, as well as depresses prices by making imports cheaper (Montoriol-Garriga, 2015). Due to the low level of inflation in the euro area, the ECB was forced to launch its own QE programme in order to maintain its price stability.

According to Montoriol-Garriga’s report (2015), the ECB's QE also stimulates the economy in form of improving agents’ economic outlooks by depreciating the euro, as they expect an increase in the value of net exports, causing an improvement of the current account to boost growth.

As seen in Figure 5, the exchange rate depreciated massively by 4.8% between April and December 2014. In January 2015, the announcement of QE and the expected interest hike by the Fed and the BoE depreciated the euro even further. This fall in the euro is evidence of investors flooding out of the European market, due to the prospect of low yields, and entering ones with higher expected returns such as the United States. Hence, this evidence is significant and indicates the effectiveness of the ECBs QE program, since the previous programs such as the LTROs and the OMT almost haven’t caused any affect on the exchange rate.

Figure 5: EUR/USD Exchange Rate

Abbildung in dieser Leseprobe nicht enthalten

Although the working of QE in different countries is widely acknowledged, it is too early to conclude final results in the European Area, due to the sluggishness of QE implying the lack of enough significant empirical evidence. Whereas the exchange rate effect was a strong evidence for the effectiveness of QE, the broader economic evidence such as inflation rate was disappointing, as it went back to the zero level in 2016. However, in my opinion, the implementation of QE is necessary in order to stay competitive against other nations (currency war) and to stimulate aggregate demand, since the previous programs did not show better economic conditions (Credit Growth and Deflation).

(1513 words)

References:

Bauer, M. & Rudebusch, G. ‘Federal Reserve Bond Purchases’, 2013, Working Paper 2011- 21. Available at: http://www.frbsf.org/publications/economics/papers/2011/wp11-21bk.pdf

Butt, N., Churm, R., McMahon, M., Morotz, A., Schanz, J., 2014, ‘QE and the Bank Lending Channel in the United Kingdom’, Bank of England, Working Paper No. 511.

Claeys, G., Leandro, Á. and Mandra, A. (2015) ‘EUROPEAN CENTRAL BANK QUANTITATIVE EASING: THE DETAILED MANUAL’, , pp. 1–4.

Fawley, Brett W., and Christopher J. Neely. 'Four Stories of Quantitative Easing'. Federal Reserve Bank of St. Louis Review 95.1 (2013): 60-74.

Gagnon, Joseph, Matthew Raskin, Julie Remache, and Brian Sack, ‘The Financial Market Effects of the Federal Reserve’s Large-Scale Asset Purchases,’ International Journal of Central Banking, March 2011, 7 (1), 3–43.

Montoriol-Garriga, J. (2015) On the need and effectiveness of the ECB’s QE. Available at: http://www.caixabankresearch.com/en/web/guest/detail news%3Bjsessionid=9404E9D3CEB2CFEDF9A09814B3C46E32?lastnewsportal_articleData =1230995%2C10180%2C1.4

Picardo, E. (2015) ‘What is A currency war and how does it work?’, in Available at: http://www.investopedia.com/articles/forex/042015/what-currency-war-how-does-itwork.asp

Taborda, J. (2016) Euro area unemployment rate | 1995-2016 | data | chart | calendar Available at: http://www.tradingeconomics.com/euro-area/unemployment-rate .

Taborda, J. (2016) Euro area inflation rate | 1991-2016 | data | chart | calendar | forecast Available at: http://www.tradingeconomics.com/euro-area/inflation-cpi .

Taborda, J. (2016) Euro area household credit growth | 2010-2016 | data | chart | calendar Available at: http://www.tradingeconomics.com/euro-area/loan-growth .

Taborda, J. (2016) Euro dollar exchange rate - EUR/USD | 1957-2016 | data | chart | calendar Available at: http://www.tradingeconomics.com/euro-area/currency .

Valiente, D. (2015) ‘The “Visible Hand” of the ECB’s Quantitative Easing’, CEPS, 407, pp. 1–13.

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Details

Title
Quantitative Easing. An evaluation of its effectiveness for the European Central Bank
College
University of Warwick
Grade
78%
Author
Year
2016
Pages
8
Catalog Number
V334442
ISBN (eBook)
9783668246010
File size
2387 KB
Language
English
Tags
Quantitative Lockerung, Quantitative Easing, Monetary Policy, Unconventional monetary policy, European Central Bank, ECB, EZB, Europäische Zentralbank, Finanzkrise, Financial Crisis, EU, Economics, Analysis, Taylor
Quote paper
Daniel Stiehle (Author), 2016, Quantitative Easing. An evaluation of its effectiveness for the European Central Bank, Munich, GRIN Verlag, https://www.grin.com/document/334442

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