Lessons from US QE and success criteria for the ECB

The ECB PSPP is not only more complex and risky than the Fed’s QE, but there also remains a broad consensus that QE will not be as effective in the Eurozone as in the US. As the Fed officially ended its program and started to raise key interest rates from the zero lower bound for the first time since the financial crisis, QE was largely viewed as a success. The efficacy of QE in the US has further been

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confirmed by a number of empirical studies. Therefore, there are some important lessons that can be learned from the US experience. In the following success criteria for QE will be outlined (Table 5).

Table 5 QE success criteria

Success criteria

Program Design Open-ended QE tied to policy goals, set of unconventional measures that target various sectors

Credibility Both size and time dimension matter: QE must be perceived as permanent, tied to policy goal Forward

guidance Clear and consistent communication about monetary policy actions to the public, threshold-based

Strategy Negative interest rate policy to encourage bank lending Structural Healthy banking sector crucial,

structural and fiscal policies

Exchange rate Depreciation of currency supports QE Exit strategy Communication about possible exit

strategies critical for credibility

The ultimate aim of QE is to affect inflation expectations and thereby lower long-term interest rates to stimulate investment and spending. However, an increase in money supply alone will not affect expectations about the future price level if QE is not perceived as being long-lasting and credible.

Therefore, both the size and time dimension of asset purchases matter for the success of QE (ECB, 2015d).

The importance of signaling through the size of purchases was confirmed by the impact of the Fed’s QE1, which was the largest in scale and thus represented a credible and impressive policy shift. But besides the scale of purchases, central bank commitment to keep an accommodative stance can only be believed if it involves a time dimension. The experience of QE2 showed that a temporary

expansion of the monetary base did not affect inflation expectations in the private sector. The Fed’s QE3 was more powerful than QE2, as it was open-ended and targeted areas with larger spreads.

Furthermore, QE3 was tied to the goal of improving labor market conditions which was at the same time clearly communicated to the public (Rosengren, 2015). Thus, contingent QE measures can be an

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important signaling tool, reinforcing the central bank commitment to keep the easing measures for as long as necessary.

While the ECB’s APP program is officially set to end in March 2017, the ECB clearly stated that easing measures will be continued for as long as necessary, until desired inflation targets are met (Draghi, 2015). The announcement effects of the PSPP on policy rates showed that the ECB was successful in signaling its policy stance. The latest expansion of the program which increased the size of monthly purchases from 60 to 80 billion euros should underline its commitment and may create confidence among market participants. The ECB further signaled its intentions through the maturity of the TLTRO’s and the assets purchased through its PSPP, adding a time dimension other than the length of the program (ECB, 2015d). A key to its success could be the set of various unconventional measures in place which target a broad basket of asset classes, at long maturities and widespread investment grades.

In addition to the balance sheet expansion, successful signaling also involves informing the public about the time dimension of the program, key policy rates, and overall market developments. If the central bank can convince the public that short-term rates will stay low for a considerate time, it can increase confidence and affect long-term rates. Forward guidance can be a powerful tool to achieve additional monetary stimulus, dependent on how credible market participants view the commitment (Williams, 2012). Inconsistent communication or actions by the central bank that are not in alignment with its guidance will not anchor expectations. The Fed realized that while calendar-based guidance was effective in influencing expectations, it could also lead to confusion. For instance, if the guidance date needed to be moved, it could be interpreted by the public as pessimism about the outlook and hurt its credibility (Dudley, 2013).

Because macroeconomic forecasts can be inaccurate, a shift to threshold-based guidance could prevent such misunderstandings but also increases its complexity. When the program is contingent on the policy goal, transparency about the state of the economy also implies information about the duration of the program (ECB, 2015d). In Europe, the uncertainty about the easing measures seemed significant given the complexity of its unique program design, its policy framework, and tools, which

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in my view could impact the credibility of the ECB. An important success factor for the ECB’s QE program is thus clear communication about its policy measures and how it will respond to changes in the macro outlook through persistent discussions with the media.

While the Fed nor the ECB explicitly targeted their exchange rates, US QE led to a depreciation of the dollar, which boosted its trade balance and thereby GDP (Neely, 2013). Similarly, the ECB’s expansion of its balance sheet showed effects through the exchange rate channel. Policy announcements of the APP were mostly accompanied by a depreciation of the Euro, which contributes to the

competitiveness of Eurozone companies (Figure 12). The expected future tightening of monetary policy in the US could further strengthen this effect. Therefore, in my opinion, the positive impact of the exchange rate channel should not be underestimated and might even be crucial for the Eurozone.

A Euro depreciation increases import prices and thus inflation while rising exports contribute to the economic recovery, lower perceived risk and encourage borrowing (Dunne, Everett, & Stuart, 2015).

This being said, the extent to which future ECB easing measures will lead to a depreciation of the Euro contributes to the success of QE in Europe.

Another lesson from US QE is that an increase in the monetary base does not automatically translate into easier monetary conditions. This is because the money multiplier has significantly decreased in the last years, which has also reduced the effect of injecting money into the economy (Smaghi, 2009).

In fact, it could be observed that while QE led to a tremendous increase in the Fed’s monetary base, money stock and inflation rates rose only moderately. With banks being reluctant to lend, increases in the monetary base fail to increase broad money supply and thus to affect inflation (Duprat, 2015b).

The ECB’s negative interest policy seems promising in incentivizing bank lending by making it costly for them to hold excess reserves. Furthermore, negative interest rates can support the exchange rate channel through currency depreciation and support lending by further easing credit conditions (Worldbank, 2015).

A few conclusions can also be drawn from the BOJ’s QE program. An important lesson learned from the Japanese QE experience was that the banking system plays a crucial role in the effectiveness of QE and a failure to recapitalize banks largely impairs the functioning of the credit channel. With the

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massive deleveraging in the Japanese economy, especially in the banking sector, banks were not willing to lend the additional liquidity received (Smaghi, 2009). The Fed acted immediately to achieve a restructuring of the financial sectors and bank recapitalization, which was largely due to pressures stemming from its capital markets-based financial system (Dudley, 2013). The ECB faces similar difficulties as Japan where monetary transmission is impaired, and companies receive most of their funding from bank loans (Folkerts-Landau, 2014). For monetary policy to be effective, a healthy financial system is crucial, which increases the importance financial and structural reforms (Dudley, 2013).

At the same time, if QE is perceived as permanent it could have expansionary effects by reducing fiscal constraints. Fiscal policy may be critical for the ECB to stimulate demand in a deflationary

environment (Smaghi, 2009). By lowering yields and raising inflation expectations, QE can mitigate the costs of ongoing fiscal consolidation, while positive inflation reduces the public debt burden. It is, therefore, important that the Eurozone does not implement new austerity measures and limit

positive effects from QE. The experience from Japan showed that despite its massive asset purchases, the lack of fiscal and structural policies hindered growth and inflation. Stronger policy coordination between Euro area governments and the ECB may thus be necessary (Blot et al., 2015).

Finally, it should be noted that asset purchase programs involve a significant risk of losses for the central banks. When government bonds are purchased at relatively high prices and QE is successful, once the economy strengthens, long-term interest rates rise and in turn bring down the prices of the bonds. Increasing concerns about the credibility and financial independence of the central bank can have negative effects on its monetary policy, as seen in the case of Japan (Smaghi, 2009). The ECB should be aware that clear communication to the public about possible exit strategies can be critical in restoring confidence and inflation. However, the Fed experience showed that communicating exit strategies too early can lead to market disruptions (Dudley, 2013). Understanding the signaling channel of QE and the interaction with forward guidance policies in affecting inflation expectations and the risk of market overreactions in the process of normalization is crucial for the ECB.

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