ECB QE prescription and its side effects
Low rates in Europe are the symptom of ‘low-flation’
Low, or negative, bond yields are now more the norm than the exception across continental Europe. They have helped to depress the bond premium globally. Behind this development is a market view that CPI inflation will remain below 2% for a protracted period, with risks skewed to the downside.
In response, the ECB has progressively administered a strong dosage of monetary stimulus centred on a large increase in excess reserves remunerated at negative rates.
The ECB’s prescription is now in the economy’s bloodstream
So far, investors remain sceptical that the ECB’s therapy will succeed. This is in contrast to our forecasts, which envisage above-trend growth, core inflation already forming a bottom, and headline inflation receiving a boost from the increase in oil prices and ‘base effects’. Based on this assumption, and a pick-up in foreign growth, we continue to forecast a steepening of the core Euro area curve.
Self-reinforcing expectations related to the implementation of QE have taken bond prices in core EMU countries to lofty levels, making them vulnerable to sharp pullbacks. This week’s price action has provided a taster.
The ‘side effects’ will have to be cured separately
The ECB’s QE and the ensuing decline in rates have come with side effects, exposing long-standing problems in the Euro area corporate pension plans and life insurances, particularly among the German non-listed sector. We think these issues will not go away even as long rates progressively rise.
Addressing them will require separate policy interventions comprising a relaxation of regulations pertaining to the asset allocation mix of these institutions alongside market-based risk management. Should capital shortfalls in the sector materialise, government interventions could be needed.
Most of the potential ‘problem cases’ are limited in size and located in core countries, where the fiscal capacity should be sufficient to prevent them from becoming a threat to the area’s financial stability.