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European Central Bank (ECB) President Mario Draghi speaks at the 28th Frankfurt European Banking Congress (EBC) at the Old Opera house in Frankfurt, Germany
REUTERS/Ralph Orlowski
Defining his legacy.
END OF AN ERA

After €2.6 trillion, Europe’s massive stimulus program ends at an awkward time

By Eshe Nelson

This is a momentous day in Frankfurt. The European Central Bank’s president, Mario Draghi, just announced the end of its massive bond-buying program. Since March 2015, the ECB commanded purchases of €2.6 trillion ($3 trillion) of debt, mostly sovereign, from across the euro zone.

Today (Dec. 13) marks the end of an era of unprecedented monetary stimulus in the region’s economy. It finally puts Europe on the same path as the US, which for the past few years has been unwinding its own stimulus from the 2008 financial crisis.

Still, there’s a problem. This new dawn for the central bank has coincided with a substantial slowdown in economic momentum. Last year, Europe was the standout surprise of the global economy, with growth at the fastest pace in a decade. So at the start of 2018, policymakers cut the bank’s bond-buying program, known as quantitative easing (QE), in half. The pace of monthly purchases was halved again in October, to €15 billion. At the same time, signs of economic pain got bigger. Germany’s economy contracted in the third quarter for the first time since 2015. The pace of growth across the whole euro zone halved. Italy embarked on a standoff with the EU over its budget that sent its bond yields soaring.

Today, the ECB’s Governing Council went to lengths to prove that even if QE is ending, hefty amounts of stimulus are not.

How did the ECB get here?

In the past decade, QE has gone from being almost unknown to mainstream monetary policy used in the US, UK, Japan, Europe, Sweden, and Switzerland. The policy of buying government bonds and other public assets is designed to boost the economy in a few ways. Firstly, the extra demand the central bank creates by its purchases pushes up the price of these bonds. That in turn lowers the yields on the bonds and therefore the borrowing costs for governments. Additionally, it causes the yields on safe government bonds to fall and so lowers the return investors get from owning the bonds. This should prompt banks and other investors to buy riskier assets, such as company debt and stocks. Also, when commercial banks sell their bonds to the central bank they have more money available to lend out to businesses and people.

The policy is not without criticism. It’s been blamed for stoking asset prices and fueling inequality. Alongside record low interest rates, QE has been criticized for hurting bank profitability.

The term “quantitative easing” first appeared in Japan. By 1999, Japan’s “lost decade” had turned a boom into a prolonged recession. This is when a policymaker at the Bank of Japan suggested they implement “quantitative easing by targeting the monetary base.” In 2001, the central bank started buying government bonds to ward off deflation. Later, equities and asset-backed securities would also be included in an ever more far-reaching attempt to boost inflation. The first program lasted four years. Since 2011, Japan has been engaged in a massive asset-purchase plan under “Abenomics” that remains far away from its end.

QE is supposed to be a last-resort policy for when all the normal stimulus measures—like cutting interest rates—have failed to spur growth and inflation. And so in the desperate times after the financial crisis when politicians and central bankers were looking for a quick way to boost economic growth, QE became popular.

And it worked. The US Federal Reserve used QE after the financial crisis, starting in 2008. Economists have concluded that that first round of purchases helped pull the American economy out of recession and certainly stopped it from turning into a depression. The Fed did several more rounds of QE that lasted until 2014. Economists have been less convinced about the effectiveness of these subsequent rounds, which eventually built up a balance sheet of $4.5 trillion.

The Bank of England started a QE program in March 2009. By July 2012, it had bought a total of £375 billion in debt. After the UK voted to leave the European Union in 2016, the bank revived its QE program amid concerns that the unexpected outcome of the vote would lead to investment and spending drying up.

The ECB was late to the game. It didn’t start purchases until five months after the US had ended its QE program. Part of the problem is politics. Germany is vehemently against anything that even whiffs of monetary financing, which is illegal under EU law, and has taken the ECB to court over various bond purchasing plans.

Europe’s sovereign debt crisis was only brought to heel by Draghi promising to do “whatever it takes” to save the euro in 2012. This seemed like a signal to markets that bond purchases could happen. At the time, words were enough. But later deflation set in and threatened the whole region’s economy, which was moving sluggishly.

Eventually in 2015, the ECB started buying government bonds in a somewhat complicated structure whereby purchases were actually made through national central banks in accordance with each country’s financial contribution to the ECB, based mostly on the size of each economy.

Today, Draghi said that for some of the past four years QE had been “the only driver of this recovery” since the financial and sovereign-debt crises.

What happens next in Europe?

While announcing its monetary policy plans, the ECB also released forecasts for economic growth and inflation. Both of which were downgraded for 2019 from three months ago. Falling oil prices are also not helping the outlook for inflation.

Draghi noted that data on the economy had been coming in weaker than expected. But he said he believed there was enough underlying domestic demand to sustain economic growth. However, he warned on a plethora of risk, including trade protectionism, emerging market troubles, and financial market volatility. Therefore, “significant” stimulus is still needed, he said.

Bill Papadakis, a strategist at Lombard Odier Private Bank, notes that in 2016 and 2017, euro zone growth slightly outpaced the US, but this year it is lagging by more than 1%– “a marked reversal of the differential.”

The ECB has committed to keeping interest rates at their current record low and negative levels at least through the summer of 2019, further reassuring markets and businesses that it’s not on exactly the same track as the US and UK, which have begun their rate hiking cycle. In fact, investors are wondering if the US is nearing the end of the  cycle that tepidly began in December 2015.

While today’s decision means the ECB won’t be materially adding to its balance sheet, it will be able to keep providing market support by reinvesting the principal payments from bond holdings that mature, keeping the size of the purchase program flat from now. Policymakers unanimously agreed to keep their time horizon for reinvestment—next year is expected to be about €200 billion— open ended. 

Many analysts are also expecting the central bank to announce new loans to banks next year. The targeted longer-term refinancing operations (TLTROs), cheap loans to banks in return for boosting credit to households and businesses, have been used to support economic growth.

Still, the ECB has committed to a path of policy normalization, hoping to join the UK and US. Next year, will be crucial to see if the economic slowdown was just temporary—and to ensure it hadn’t misstepped.