This week’s encouraging data from Europe, including the decent eurozone Purchasing Managers Index numbers for February released Tuesday, confirm that the continent is on a well-trodden quantitative-easing path that has already been followed in the U.S. and Japan.
Europe's QE Quandary
With this in mind, here are nine things to know about the European Central Bank’s QE, ranging from what has already occurred to what is likely to take place.
- Expectations of QE, especially when reinforced with official confirmation of policy intentions, lead to out-performance by equities and currency depreciation. That is what happened, in sequence: first in the U.S., after the Federal Reserve's 2010 announcement of a second round of asset purchases and the subsequent rounds of QE; then in Japan, once the central bank shifted to a more stimulative QE stance under its new governor, Haruhiko Kuroda, in 2013; and most recently, it has been taking place in Europe since ECB President Mario Draghi signaled his QE intentions last year.
- The financial markets' reaction provides an immediate shot in the arm to sentiment, illustrated by encouraging upward movement in closely followed survey-based indicators, such as consumer confidence. Initially, both the corporate segment and households tend to respond enthusiastically to central banks that are seen as more engaged in stimulating economic activity.
- Some of this sentiment improvement translates into greater economic activity. This tends to be concentrated in sectors with shorter time horizons, especially those for which the gestation period for investments is more limited.
- Encouraged by the improved context, governments are happy to become even more dependent on central banks to do the heavy lifting. Rather than build on the positive momentum by implementing measures that support central bank efforts, governments revert to an even more passive economic policy role.
- The QE-inspired configuration of financial asset prices increases the taxing of savers and the subsidizing of debtors. In the process, the institutions that provide long-term financial services to consumers, such as life insurers, are undermined by unconventional monetary efforts to rehabilitate banks and the economy. Meanwhile, wealth inequality worsens because the ownership of stocks is heavily concentrated among the better-off segments of society.
- Excitement about surging financial markets slowly gives way to worries about bubble formation and inappropriate resource allocations. These concerns start among analysts and economists. They then shift to policy makers (as illustrated by the comments this week of current and former Fed officials such as James Bullard, Stanley Fischer and Richard Fisher). Eventually, even market participants start to worry about sustainability.
- Meanwhile, the QE-inspired bounce in sentiment and activity struggles to pick up lasting momentum based on genuine growth drivers. The reason for this is simple: Lacking the support of more comprehensive policy measures by governments, central bank stimulus alone isn't able to overcome the structural demand and debt impairments to durable economic expansion and prosperity.
- Despite mounting concerns and growing economic disappointments, there is little urgency among either the public or the private sector to exit the “central bank trade.” This reluctance isn't caused by a lack of understanding of the increasing risks of collateral damage and unintended consequences. Rather, it reflects the belief that, although it is far from ideal, central bank experimental activism is the best among the set of suboptimal options. Indeed, while it is far from being the most desirable solution, it may be the only feasible option at this stage for governments and markets that live predominantly in the short-term.
- Having staked their effectiveness and credibility on a hand-off to a more comprehensive governmental policy response, central banks find their operational autonomy increasingly challenged. Political talk of stronger audit and accountability standards increases, as does the risk of politicizing institutions that are among the most important and influential crisis first responders.
History suggests that these nine factors will continue to play out in Europe, as they have in economies that embarked on QE earlier. Indeed, that is the easy prediction.
The harder one pertains to the ultimate destination — and in particular, whether, when and how governments will finally step up to their economic governance responsibilities. That is a crucial chapter that has yet to be written in Japan and the U.S., let alone in Europe.
To contact the author on this story: Mohamed El-Erian at [email protected]
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