The price of two percent inflation

Though it is still considered a rather unconventional form of monetary policy, quantitative easing (QE) has become a commonly used tool of central banks around the world. It involves the central bank purchasing government bonds and other financial assets from the market.  First used in Japan in the 2000s and later in the US in the wake of the 2008 financial crisis, with the Federal Reserve consecutively launching three QE programmes in order to stimulate the economy. Other central banks such as the Bank of England and the European Central Bank (ECB) soon followed.

Quantitative easing is an expansionary monetary policy in which the central bank buys vast amounts of debt to increase liquidity and stimulate the economy. When a country is faced with the threat of deflation, a common response of the central bank is to decrease the key interest rate and thus raise inflation. However, when the interest rates are already at around zero, the central bank is caught in a liquidity trap, where standard monetary policy becomes ineffective. Then, it resorts to QE to prevent deflation. On top of increasing liquidity, buying large quantities of government debt allows it to influence long-term interest rates, something on which its standard monetary policies have no effect.

One of the primary tasks of a central bank is to provide price stability, which means keeping the inflation rate close to zero. However, as common practice, central banks often try to keep inflation at around two per cent, since this is neither high enough to be harmful to the economy, nor is there an immediate risk of deflation.

As a response to the European debt crisis, the ECB has lowered the key interest rates close to zero. Thus, when in 2014 inflation in the euro area dropped, with core inflation just above 0.5% and the consumer price index even turning negative, the European System of Central Banks (ESCB) started the asset purchase programme (APP), a QE programme where the government debt of each eurozone state was acquired by their respective central bank. The programme started in March 2015 with an average monthly net purchase of 60 billion euros. As the graph shows, this amount varied throughout the following years, peaking at 80 billion euros and being reduced to a minimum of 15 billion in September 2018, as the programme is supposedly coming to a gradual end. In total, the ESCB currently holds around 2.5 trillion euros as a result of APP.

Second picture
Inflation in the Euro area

An intervention of such a magnitude on financial markets does not go without less intended effects. Let us start by stating the seemingly obvious: inflation in the euro area increased throughout (as it can be seen in the graph) and most probably as a direct result of APP and is now at approximately the targeted level of two per cent. Thus far, QE achieved its purpose.

Curiously, the effect of APP on the inflation rate turned out considerably smaller than anticipated. Apart from intriguing macroeconomists around the globe, this phenomenon poses a potential risk to the European economy. Could the effect on the inflation rate simply be delayed, resulting in excessive and harmful inflation in the coming years? Critics of QE often name this as a risk of the policy. However, the central bank usually has the possibility to counterbalance this effect by reducing its holdings, which would usually diminish inflation.  This strategy too has its own risks. If applied too drastically, it could lead to deflation, the very phenomenon QE is trying to prevent. In between 2012 and 2014, the ECB reduced its holdings by around one trillion euros and simultaneously core inflation dropped by one percentage point, which arguably caused the ECB to create the current QE programme. It seems like preventing either too much or too little inflation is just a matter of finding the right equipoise. It is important to note that our understanding of inflation is at best incomplete and, thus policy makers should be on guard for potential unforeseen effects.

Another side effect of QE is the inevitable decrease in profitability of saving. Whether you are putting aside money for your retirement or the education of your kids, the growth of your savings is dramatically decreased by low interest rates. A less commonly named, but nonetheless momentous cause of the growing support for right wing populist parties, is voters having the feeling of being cheated for their saving yields. In addition, the low interest rates do not only disadvantage private savers, but also any institution financing itself through capital gains on a capital fund.

What differentiates APP from previous QE programmes in Japan or the US is the fact that because of the common currency, it has to be applied simultaneously in all eurozone states, in order for it to be effective. This can create several major complications.

First off, in any country applying QE, there is risk that the debt bought by the central bank is not repaid. In the case of private debt, this is a minor problem since the amounts bought from one institution are relatively small. Further, as long as the state is in a “healthy” situation regarding its debt, purchases in the public sector bear little risk since they effectively only consist of money transfers between two components of public authority.

However, the situation becomes significantly more complicated in the multinational construct of states. Let us take a closer look at the way the European QE programme is constructed. APP is the superordinate term comprising several different programmes, the largest of which is the public sector purchase programme (PSPP) making up around 80% of the APP.

First picture
APP monthly net purchases, by programme

The government bonds are acquired by the ESCB, in the way that each central bank buys exclusively from the government of its country. This regulation was created to prevent one country (or their central bank) having to step in to avert the bankruptcy of another state. This, in principle seems to be a clear regulation consistent with article 125 of the Lisbon treaty (TFEU), better known as the “no bail out” clause, stating that the union or any member state “shall not be liable for or assume the commitments of central governments”. However, the PSPP resolution empowers the ECB council to distribute the liabilities for the acquired bonds on all eurozone states in exceptional circumstances. In such an event, would a redistribution of liabilities be in accordance with the treaties, and what would be its consequence for the eurozone states?

In July 2012, Mario Draghi announced, “the ECB is ready to do whatever it takes to preserve the euro.” This statement was put into consequence through the OMT (Outright Monetary Transactions) programme announced in September 2013. Yet, the programme was never actually executed since the mere announcement was sufficient to calm financial markets. Investors no longer feared that a European state would be unable to repay its debts.

The significance of Mario Draghi’s statement is twofold. On the one hand, it succeeded in averting a possible crisis. On the other hand, it shows the ECB’s determination to prevent a state bankruptcy even if this means making other member states liable for the commitments of the insolvent state, the legal status of which is at least questionable.

However, the problem has another, more structurally profound component. The assurance that a state facing bankruptcy will be saved, leads to the moral hazard of no state having a sufficient incentive to reduce its debt. Why restrict yourself to a balanced budget or at least one leading to a sustainable debt situation, when you can have the benefits of an expanded budget without having to suffer its negative consequences?

In the eurozone this problem of moral hazard is not only embedded in the possibility of OMTs, it is already in practice through quantitative easing. Firstly, states are almost encouraged to incur more debt by the ECB keeping the interest rates artificially low. Secondly, the ECB is practically providing the money for them to incur more debt by buying their bonds. Now, article 123 of the TFEU states that “direct purchases” of debt of member states’ government institutions by the ESCB are prohibited, but since the QE purchases are exclusively conducted on secondary markets, it is not clear whether this actually counts as a “direct purchase”. This question along with the one on a possible breach of article 125 TFEU as explained above is currently being debated before the European Court of Justice.

Putting aside the legal controversies surrounding QE in Europe, the question arises whether the risks connected to this policy do not outweigh its benefits. Is it beneficial to condone low saving yields, uncertainty of future inflation, and the moral hazard of incentivising the issuance of debt, just to raise inflation to two per cent? Or is the financing of indebted states part of an unofficial purpose of APP? Both questions are hard to answer. Independent of any precise answer or opinion, it is important to realise the functioning and the effects of APP that distinguish it from precedent QE programmes in other countries.

by Konrad Lucke



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