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Nerves set in as ECB unbottles policy genie

EconomyMar 13, 2015 08:55AM ET
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2/2 © Reuters. Inflated euro sign is seen outside the new headquarters of the European Central Bank (ECB) in Frankfurt 2/2

By Paul Carrel

FRANKFURT (Reuters) - For the first time in years, the European Central Bank is embarking on a policy course with a following wind. But already some officials are fretting that the gale they are unleashing may turn into a hurricane.

The concern is that the bond-buying plan launched on Monday to pump more than a trillion euros into the 19-country economy will send stronger members such as Germany that could arguably do without the support into overdrive, while fostering complacency among laggards.

The plan is aimed at lifting euro zone inflation from below zero back up toward the ECB's target of just under 2 percent. But the risk is that it inflates real estate and share price bubbles and might cause Europe's biggest economy, which already has record low unemployment of 6.5 percent, to overheat.

Such a scenario could widen the gap between rich and poor member states, further stretching the already strained fabric of European integration, tested again this week when Greece's finance minister accused the ECB of "asphyxiating" Athens.

On the face of it, the ECB is upbeat.

The central bank projects its plan to print money to buy sovereign bonds – so-called quantitative easing (QE) – will turbo-charge a frail euro zone recovery that is already being helped by lower oil prices and a revival in bank lending.

This is crucial. Had the ECB launched the plan last year when growth was stagnant and banks were reining in credit, the new money would have had a harder time finding its way into the economy - and the stimulus might have fallen flat.

"We did it just at the turning point," one senior euro zone central banker said of the QE launch, confident the plan can help buoy the economy and lift inflation.

The ECB and its constituent national central banks plan to spend 60 billion euros ($63.66 billion) a month, mainly on sovereign bonds, until at least September 2016.

Buying sovereign bonds will hold down governments' borrowing costs and keep market interest rates low, encouraging investors to move into riskier assets that will spur growth, while also pushing down the euro currency.

However, the speed and the extent of the euro's <EUR=> fall -- it has tumbled 12.5 percent against the dollar so far this year, well on track for the biggest quarterly loss since its launch in 1999 -- has taken many at the ECB by surprise.


Some ECB policymakers are concerned about the effects of the policy genie they have unbottled, particularly the risks attached to pinning market interest rates below zero.

"I'm a bit nervous about this -- that there might be something like too much success," Governing Council member Ewald Nowotny said this week. "I have the feeling we do not understand the full effect of negative interest rates in many instances."

Updated forecasts by ECB staff this month projected the QE program will raise growth rates in the euro zone and lift inflation from below zero up to 1.8 percent in 2017 - in line with the ECB's goal of just under 2 percent.

The ECB was conservative, predicting growth accelerating from 1.5 percent this year to 2.1 percent in 2017. In December, it predicted growth of just 1.0 percent this year. Private economists say further falls in the euro mean growth and inflation could outpace the upgraded ECB estimates.

The risk is that QE will, as Nowotny says, bring too much success -- particularly in those countries that need it least. The dynamics of the program will pin down borrowing costs in Germany just as a consumer-led boom is taking off.

Under the plan, the overall volume of central bank bond purchases will be constant in a given country even if yields on some maturities hit the -0.20 percent level the ECB has set as a floor for purchases - equivalent to its overnight deposit rate.

The national central bank in the country concerned - such as Germany - would have to redirect its firepower to buy other maturities to keep the total volume of the plan steady.

With yields on German sovereign bonds with maturities of up to 3 years around or below -0.20 percent, the lower limit for ECB purchases, a disproportionate amount of money will be thrown at longer-dated German securities compared to other countries.

The bottom line: borrowing costs will stay particularly low for Germans - just as inflation-beating wage deals and a little more government investment point to a robust rebound this year.

Some economists acknowledge that QE may not be appropriate for Germany but are resigned to the plan given the one-size-fits-all nature of monetary policy in the single currency area.

"In Germany, you have a situation where we're moving towards over-potential," an adviser to the Berlin government said. "But we're in the monetary union, so there is one (monetary) policy."

Bundesbank chief Jens Weidmann told Reuters on Thursday the German economy's "very robust shape" meant the national central bank would raise its growth forecast for this year to around 1.5 percent from 1.0 percent seen in December.

Klaas Knot, the Dutch central bank chief, warned that ECB bond purchasing may cause asset bubbles in some high-yield bonds, government debt, and stocks.

"In a while it will be harder to identify the sectors where there is no misalignment than to identify the sectors where there is misalignment, I'm afraid," Knot said.

Both Knot and Weidmann, two leading ECB hawks, opposed the QE plan. Nowotny and others at the ECB share their concerns.

"Germany is not exploding... but we must be careful," said another senior euro zone central banker, adding that national authorities can always implement measures to keep the financial system on an even keel, such as setting limits on the multiples people can borrow to buy a home.


At the same time, the arrival of a guaranteed buyer of sovereign debt may bring temptations for the euro zone's weaker economies, including France, which is worrying ECB officials with its go-slow approach to budget consolidation.

"That can, of course, lead to bad habits and to countries putting off the necessary consolidation of public budgets," Weidmann said of the guaranteed-buyer factor.

If euro zone laggards let slip efforts to put their public finances in order, they could lumber future administrations with a bigger bill when borrowing costs rise, undermining any long-term recovery and further straining the euro zone's cohesion.

Even if growth of the whole bloc accelerates and a debate ensues about tapering QE, many states risk trailing behind Germany, blighted by a lack of investment in recent years.

"While the central scenario is that QE should help on inflation and on (economic) activity, it's difficult to pinpoint exactly what the effect should be," said Francesco Papadia, a former ECB director general for market operations.

"There is more uncertainty around it, which doesn't mean that you shouldn't do it because in a cost-benefit calculation not doing it would be even worse."

Nerves set in as ECB unbottles policy genie

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