Fitch Sees QE as Reducing Europe’s Deflation Risk

The European Central Bank’s (ECB) large and potentially open-ended
asset purchase programme
reduces the risk of prolonged deflation in the eurozone through a weaker euro and a boost to confidence, says Fitch Ratings. However, its ultimate effectiveness in raising inflation and growth remains highly uncertain.

The credit ratings agency (CRA) adds that the newly-announced programme should help underpin inflation expectations, and supports its base case that, in the context of a very modest economic recovery, the eurozone will avoid prolonged deflation. The policy should also take effect through boosting asset prices and leading to a weaker euro.

However, the expanded programme’s effectiveness in easing financial conditions and its transmission to the real economy is uncertain. The large role of banks in credit intermediation means that as they continue to delever and strengthen their balance sheets the boost to credit supply may be less than anticipated. Eurozone banks have received substantial liquidity (the ECB also removed the 10 basis points (bp) spread between targeted longer-term refinancing operations and main refinancing operations), suggesting that credit demand is muted due to high unemployment and economic uncertainty.

Only 20% of additional assets purchased will be subject to risk-sharing across the Eurosystem, as purchases of securities issued by European institutions (12% of additional asset purchases) will be subject to loss sharing, and the ECB (rather than national central banks) will hold 8% of the additional asset purchases.

This limited risk sharing highlights the limits of eurozone integration and the lack of fiscal union, despite substantial progress. Fitch doesn’t think it will necessarily affect the aggregate monetary policy impact, although it could weaken the boost to confidence. The ECB emphasised that governments and the European Commission also need to support growth through structural reforms and fiscal consolidation that is designed to minimise the adverse impact on growth while complying with the EU’s fiscal rules.

The ECB said the Eurosystem will accept pari passu treatment with private investors (as with Outright Monetary Transactions [OMT]). This may reduce the likelihood that bond investors demand a risk premium for implied subordination.

The ECB said that it will add sovereign bond purchases to its existing private sector asset purchase programmes. Combined monthly purchases of public and private sector securities will total EUR60bn and are “intended” to be carried out until end-September 2016, or the ECB sees “a sustained adjustment in the path of inflation” consistent with its inflation target. The ECB had been widely expected to launch public-sector quantitative easing (QE).

The ECB’s balance sheet is €2,158bn, 21% of eurozone gross domestic product (GDP). Combined purchases that increased the balance sheet by €60bn a month until September 2016 would expand it by around €1,140bn to nearly €3,300bn, 33% of GDP, all other things being equal. This would make it larger than the Federal Reserve (26%) and the Bank of England (22%) as a proportion of GDP, although significantly smaller than the Bank of Japan (over 60%).

The asset purchases will be of maturities from two to 30 years and in accordance with the ECB’s capital key, subject to certain eligibility criteria. Greece is excluded while its financial assistance programme is under review.

The ECB announcement follows various easing measures, including interest rate cuts in June and September 2014 that led to negative deposit rates, and the targeted long-term refinancing operation (TLTRO) programme. The ECB also started buying asset-backed securities ABS and covered bonds, a form of private-sector QE, but the size of these programmes is small (TLTROs and the combined ABS and covered bond purchases total €212bn and €35bn, respectively).

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