The ECB on neutral ground?

By Christophe Blot and Jérôme Creel

The involvement of the European Central Bank (ECB) in the fiscal management of the euro area member states has been a subject of ongoing controversy. Since the implementation of the ECB programme to purchase sovereign debt, it has been accused of profiting off of troubled states and taking the risk of socializing losses. The rise of these controversies results from the difficulty in understanding the relationship between the ECB, the national central banks (NCBs), and the governments. The European monetary architecture comes down to a sequence of delegations of power. Decisions on the conduct of monetary policy in the euro area are delegated to an independent institution, the European Central Bank (ECB). But, under the European subsidiarity principle, the implementation of monetary policy is then delegated to the national central banks (NCBs) of the euro area member states: the ECB and NCBs taken together are called the Eurosystem. While up to now this dimension of the organization of the euro area’s monetary policy has not attracted much attention, debate has recently arisen in the course of the implementation of the quantitative easing programme. According to commentators and journalists, some national central banks are profiting more than others from the policy of buying and supporting their national public debts, which are riskier than the debt in more “virtuous” countries[1]. The profiting banks are viewed as escaping the ECB’s control and not strictly applying the policy decided in Frankfurt.

In a recent paper prepared as part of the European Parliament’s Monetary Dialogue with the ECB, we show that these concerns are unfounded for the simple good reason that, on average, since the beginning of the implementation of this policy, the theoretical distribution key has been respected (graphic). This distribution key stipulates that purchases of bonds by the Eurosystem are to be made pro rata to a state’s participation in the ECB’s capital. Remember that part of the purchases – 10 of the 60 billion in monthly purchases made under the programme – are made directly by the ECB[2]. The other purchases are made directly by the NCBs. As each central bank buys securities issued by its own government, the NCBs’ purchases of public bonds do not entail risk-sharing between member states. Any profits or losses are kept on the NCBs’ balance sheets or transferred to the national governments in accordance with the agreements in force in each country.

This distribution of public bond purchases, which is intended to be neutral in terms of risk management, isn’t entirely so, but not for the reasons that seem to have worried the European Parliament’s Committee on Economic and Monetary Affairs. This distribution favours the maintenance of very low rates of return on the debts of certain member states. In fact, by not basing itself on the financing needs of the member states or on the size of their public debts, it can produce distortions by reducing the supply of public bonds available on the secondary markets. Such may be the case in Germany, Spain and the Netherlands, whose shares of the European public debt are smaller than their respective shares in the ECB’s capital (table). Conversely, the purchases of Italian bonds are smaller with the current distribution key than they would be with a distribution key that took into account the relative size of the public debt. The ECB’s policy therefore has less impact on the Italian debt market than it does on the German market.

This orientation could also constrain the ECB’s decision about continuing quantitative easing beyond December 2017. Let’s agree that the ECB’s best policy would be to continue the current policy beyond December 2017, but to stop it once and for all in July 2018. Given the current distribution rules, this policy would be subject to all countries having exchangeable government bonds until July 2018, including those who issue public debt only rarely because they have low financing needs. It could be that it is impossible to continue this policy under the rules currently adopted by the ECB, because some countries do not have sufficient debt available. It would then be necessary to implement a different policy by drastically reducing the monthly purchases of short-term securities (say in January 2018), while possibly pursuing this policy for a longer time period (beyond the first half of 2018). The decision not to use risk-sharing in the management of European monetary policy is therefore far from being neutral in the way this policy is actually implemented.

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[1] Mario Draghi was questioned about the distribution of the public sector purchase programme (PSPP) at the press conference he held on 8 September 2017.

[2] There is risk-sharing on this sum: the gains or losses are shared by all the NCBs in proportion to their contribution to the ECB’s capital.

 

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The ECB is extending its QE programme but mixes up its communications

By Paul Hubert

On Thursday, March 10, after the meeting of its Governing Council, the European Central Bank (ECB) announced a series of additional measures for the quantitative easing of monetary policy. The aim is to prevent the onset of deflation and to boost growth in the euro zone. The key innovation lies in the measure for bank financing at negative rates. While the measures were well received by the markets at the time of the announcement, a lapse in Mario Draghi’s communications during the press conference following the Board of Governors meeting greatly undercut some of the impact expected from the decisions taken. Continue reading “The ECB is extending its QE programme but mixes up its communications”

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Do QE programmes create bubbles?

By Christophe Blot, Paul Hubert and Fabien Labondance

Has the implementation of unconventional monetary policies since 2008 by the central banks created new bubbles that are now threatening financial stability and global growth? This is a question that comes up regularly (see here, here,  here or here). As Roger Farmer shows, it is clear that there is a strong correlation between the purchase of securities by the Federal Reserve – the US central bank – and the stock market index (S&P 500) in the United States (Figure 1). While the argument may sound convincing at first glance, the facts still need to be discussed and clarified. First, it is useful to remember that correlation is not causation. Secondly, an increase in asset prices is precisely a transmission channel for conventional monetary policy and quantitative easing (QE). Finally, an increase in asset prices cannot be treated as a bubble: developments related to fundamentals need to be distinguished from purely speculative changes.

Higher asset prices is a factor in the transmission of monetary policy

If the ultimate goal of central banks is macroeconomic stability [1], the transmission of their decisions to the target variables (inflation and growth) takes place through various channels, some of which are explicitly based on changes in asset prices. Thus, the effects expected from QE are supposed to be transmitted in particular by so-called portfolio effects. By buying securities on the markets, the central bank encourages investors to reallocate their securities portfolio to other assets. The objective is to ease broader financing conditions for all economic agents, not just those whose securities are targeted by the QE programme. In doing this, the central bank’s actions push asset prices up. It is therefore not surprising to see a rise in equity prices in connection with QE in the US.

Every increase in asset prices is not a bubble

Furthermore, it is necessary to make sure that the correlation between asset purchases and their prices is not just a statistical artefact. The increase observed in prices may also reflect favourable fundamentals and be due to improved growth prospects in the United States. The standard model for determining the price of a financial asset identifies its price as equal to the present value of anticipated income flows (dividends). Although this model is based on numerous generally restrictive assumptions, it nevertheless identifies a first candidate, changes in dividends, to explain changes in stock prices in the United States since 2008.

Figure 1 shows a clear correlation between the series of dividends [2] paid and the S&P 500 index between April 2010 and October 2013. Part of the rise in equity prices can be explained simply by the increase in dividends: the usual determinant of stock market prices. Looking at this indicator, only the period starting at the beginning of 2014 could then indicate a disconnect between dividends and share prices, and thus possibly point to an over-adjustment.

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A correlation that isn’t found in the euro zone

If the theory that unconventional monetary policies create bubbles is true, then it should also be observed in the euro zone. Yet performing the same graph as the one for the United States does not reveal a link between the liquidity provided by the European Central Bank (ECB) and the Eurostoxx index (Figure 2). The first phase in the increase in the size of the ECB’s balance sheet, via its refinancing operations starting in September 2008, came at a time when stock markets were collapsing, following the bankruptcy of Lehman Brothers. Likewise, the very long-term refinancing operations carried out by the ECB at the end of 2011 do not seem to be correlated with the stock market index. The rise in share prices coincides in fact with Mario Draghi’s statement in July 2012 that put a halt to concerns about a possible breakup of the euro zone. It is of course possible to argue that the central bank has played a role, but any link between liquidity and asset prices is simply not there. At the end of 2012, the banks paid back their loans to the ECB, which reduced the cash in circulation. Finally, the recent period is once again illustrating the fragility of the argument that QE creates bubbles. It is precisely at a time when the ECB is undertaking a programme of large-scale purchases of securities, along the lines of the Federal Reserve, that we are seeing a fall in world stock indices, in particular the Eurostoxx.

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So does this mean that there is no QE-bubble link?

Not necessarily. But to answer this question, it is necessary first to identify precisely the portion of the increase that is due to fundamentals (dividends and companies’ share prospects). A bubble is usually defined as the difference between the observed price and a so-called fundamental value. In a forthcoming working paper, we endeavour to identify periods of over- or undervaluation of a number of asset prices for both the euro zone and the United States. Our approach involves estimating different models of asset prices and thereby to extract a component that is unexplained by fundamentals, which is then called a “bubble”. We then show that for the euro zone, the ECB’s monetary policy broadly speaking (conventional and unconventional) does not seem to have a significant effect on the “bubble” component (unexplained by fundamentals) of asset prices. The results are stronger for the United States, suggesting that QE might have a significant effect on the “bubble” component of some asset prices there.

This conclusion does not mean that the central banks and the regulators are impotent and ignorant in the face of this risk. Rather than trying to dissect every movement in asset prices, the central banks should focus their attention on financial vulnerabilities and on the ability of agents (financial and non-financial) to absorb sharp fluctuations in asset prices. The best prevention against financial crises thus consists of continuously monitoring the risks being taken by agents rather than trying to limit variations in asset prices.

[1] We prefer a broad definition of the end objective that takes into account the diversity of institutionalized formulations of the objectives of central banks. While the mandate of the ECB is primarily focused on price stability, the US Federal Reserve has a dual mandate.

[2] The series of dividends paid shows strong seasonality, so this has been smoothed by a moving average over 12 months.

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What would be the risks of extending QE?

By Christophe BlotPaul Hubert and Fabien Labondance

Following the last meeting of the ECB Governing Council on 22 October, Mario Draghi said that on Thursday, December 3rd, the Bank would review the orientation of its monetary policy in the light of economic and financial developments and the new Eurosystem staff forecasts, which will be disclosed at that time. The main issue facing the meeting is whether the ECB will take new steps to support activity. It could for instance announce further cuts in the deposit facility rate or an extension of quantitative easing (QE). Up to now the ECB has been careful to show its determination to meet its primary objective of price stability, even though in return it is encountering criticism that these waves of monetary expansion have had little effect on inflation but are fuelling asset price bubbles. Continue reading “What would be the risks of extending QE?”

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Quels sont les risques d’une extension du QE ?

par Christophe Blot, Paul Hubert et Fabien Labondance

A l’issue de la dernière réunion du Conseil des gouverneurs du 22 octobre, Mario Draghi a indiqué que la BCE réexaminerait, ce jeudi 3 décembre, l’orientation de sa politique monétaire à l’aune des développements économiques et financiers et des nouvelles prévisions du staff de l’Eurosystème qui seront divulguées à cette occasion. Le principal enjeu de cette réunion est de savoir si la BCE mettra en œuvre de nouvelles mesures de soutien à l’activité. Elle pourrait par exemple annoncer une nouvelle baisse du taux des facilités de dépôts ou une  extension du programme d’assouplissement quantitatif (QE). La BCE a jusqu’ici pris soin de montrer sa détermination à remplir son objectif premier de stabilité des prix, quitte à essuyer en retour certaines critiques arguant que ces vagues d’expansion monétaire n’ont que peu d’effet sur l’inflation mais alimentent des bulles de prix d’actifs. Continue reading “Quels sont les risques d’une extension du QE ?”

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The planetary alignment has not always been favourable to the euro zone countries

By Eric Heyer and Raul Sampognaro

In 2015, the euro zone economies will benefit from a favourable “planetary alignment” (with the euro and oil prices down and financial constraints on the economy easing), which should trigger a virtuous circle of growth. Over the previous four years (2011-2014), the “planetary alignment” that existed was in a diametrically opposite direction: the euro and oil prices were high, with financing conditions and the fiscal stance very tight.

In a recent article, we propose an evaluation of the impact of these four factors on the economic performance of six major developed countries since 2011 (France, Germany, Italy, Spain, the UK and USA). Continue reading “The planetary alignment has not always been favourable to the euro zone countries”

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The coming recovery

By the Analysis and Forecasting Department, under the direction of Eric Heyer and Xavier Timbeau

This text summarises the OFCE 2015-2016 economic outlook for the euro zone and the rest of the world

While up to now the euro zone had not been part of the global recovery, the conjunction of a number of favourable factors (the fall in oil prices and depreciation of the euro) will unleash a more sustained process of growth that is shared by all the EU countries. These developments are occurring at a time when the massive and synchronised fiscal austerity that had pushed the euro zone back into recession in 2011 is easing. The brakes on growth are gradually being lifted, with the result that in 2015 and 2016 GDP should rise by 1.6% and 2%, respectively, which will reduce unemployment by half a point per year. This time the euro zone will be on the road to recovery. However, with an unemployment rate of 10.5% at the end of 2016, the social situation will remain precarious and the threat of deflation is not going away. Continue reading “The coming recovery”

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The ECB’s quantitative easing exercise: you’re never too young to start

By Christophe BlotJérôme CreelPaul Hubert and  Fabien Labondance

The ECB decision to launch a quantitative easing (QE) programme was widely anticipated. Indeed, on several occasions in the second half of 2014 Mario Draghi had reiterated that the Governing Council was unanimous in its commitment to take the steps needed, in accordance with its mandate, to fight against the risk of a prolonged slowdown in inflation. Both the scale and the characteristics of the ECB plan announced on 22 January 2014 sent a strong, though perhaps belated signal of the Bank’s commitment to fight the risk of deflation, which has been spreading in the euro zone, as can be seen in particular in inflation expectations over a two-year horizon (Figure 1). In a special study entitled, “Que peut-on attendre du l’assouplissement quantitatif de la BCE?” [“What can we expect from the ECB’s quantitative easing?”], we clarify the implications of this new strategy by explaining the mechanisms for the transmission of quantitative easing, drawing on the numerous empirical studies on previous such programmes in the US, the UK and Japan. Continue reading “The ECB’s quantitative easing exercise: you’re never too young to start”

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What is a weaker euro likely to mean for the French economy?

By Bruno Ducoudré and Eric Heyer

Faced with the rising risk of deflation in the euro zone, which has been reinforced since mid-2012 by the continued appreciation of the euro against other currencies, the heads of the European Central Bank have begun to change their tone in their communications with the financial markets: they are now evoking the possibility of conducting a new round of quantitative easing. These measures are likely to lower the exchange rate of the euro. This would provide valuable support for the euro zone economies by shoring up their price competitiveness vis-à-vis competitors outside the zone, in a context where fiscal consolidation policies will continue to dampen the growth expected in the zone in 2014 and 2015. What are the likely consequences for the French economy from reducing the euro’s value against other currencies? We briefly review past episodes of exchange rate changes, and then present the impact expected from a 10% depreciation of the euro against other currencies using the emod.fr model. These effects are more moderate than those projected by the government. Continue reading “What is a weaker euro likely to mean for the French economy?”

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The ECB – or how to become less conventional

By Jérôme Creel and Paul Hubert

The gloomy economic situation in the euro zone and the deflationary risks it is facing are leading the members of the European Central Bank (ECB) to consider a new round of quantitative easing, as can be seen in recent statements by German, Slovakian and European central bankers. What might this involve, and could these measures be effective in boosting the euro zone economy? Continue reading “The ECB – or how to become less conventional”

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