Running out of positive yield
Europe is facing a net saving glut chasing too few risk-free financial assets. This has already brought interest rates in Germany, the zone’s provider of the asset of reference, to negative territory at the short end of the curve, and below the natural level that trend nominal GDP growth would call for at the longer end of the curve. This, we think understandably, fuels fears of potential domestic asset bubbles and naturally creates local pressure for a less loose monetary policy stance.
But what is the alternative?
We argue here that, counter-intuitively, in the medium run downward pressure on German yields would be lower with QE, relative to a counterfactual “world without QE” which would be consistent with further flight to quality. Indeed, even after the steep decline in bond yields which started in 2012, market interest rates, and even more clearly bank lending rates, were still markedly above equilibrium – the level consistent with the new trend for nominal GDP growth – in most of the periphery. In other words, risk premia are still substantial – at least before the market started pricing QE more aggressively, probably reflecting underlying public finances. A nagging problem with risk premia is that, if sustained, they can be self-fulfilling and jeopardize private and public debt sustainability. QE, by shifting ex ante real interest rates to a level consistent with potential GDP growth, would not only support long term inflation expectations, but would also contribute to debt sustainability.
The lesser of two evils
We also argue that direct purchases of government bonds across of a wide array of constituencies would not necessarily increase Germany’s potential value-at-risk in the rest of the Euro area, and finally, that the counter-example of Switzerland suggests that, for a strong and stable economy, being out of a monetary union can ultimately force the central bank to take massive foreign-related risks. We think that German Finance Minister Schaueble’s very finely balanced statement on QE, in his interview with Bild Zeitung on 28 September, in which he refrained from throwing his full weight behind Jens Weidmann’s arguments, reflects an awareness in Berlin that bond buying by the central bank, however unpleasant to the German public opinion, may well be the lesser of two evils.
Be careful what you wish for
The debate within the Governing Council seems to focus on how to deal with the risk to the Eurosystem’s balance sheet that QE would create. One possibility would be for the bond buying to focus on AAA bonds only. However, this would only likely have an indirect effect on inflation expectations and debt sustainability conditions in the periphery. Such restricted version of QE would even more massive purchases that a more evenly-spread buying. Germany would get exactly the opposite of what it wants. Domestic interest rates would immediately fall steeply into negative territory, given the central bank’s concentrated buying, while further flight to quality towards German assets could not be avoided, generating a continuing downward pressure on German yields beyond the mechanical impact of ECB purchases.