Friday, March 27, 2015

ECB QE: Too Early to Declare Victory

Some misguided report in the media.

They are already declaring ECB QE a winner and more potent than the Fed, or the BoJ, citing yield compression (as opposed to an actual sell-off in case of US, and no move in case of Japan). Of course this is a completely wrong way to look at QE!

A QE is a monetary tool used to influence real rate when the nominal rates are stuck at zero lower bounds. Central bankers promises inflation targeting (mostly) and if markets believe them, a rate cut is basically lowering of real rates (as inflation expectation does not change much). However since at ZLB, you cannot cut nominal rates much further, the way to influence real rates is asset purchase. This is supposed to influence the inflation expectation upwards. So even if the nominal rates do not move, you have effectively achieved a rate cut.

And this is exactly what happens! For Fed, or BoJ and also for ECB. And yes, as expected Fed has been far more effective. In the policy moves after the initial crisis settled in (QE2/ Twist/ QE3) we have the 5y inflation break-even move 125bps/ 70bps/ 60 bps respectively. If we take relative move (i.e. the difference in break-even moves between the US and Eurozone, in order to filter global effect, if any), the figures are 35bps/ 30bps/ 25bps respectively. 

For ECB, the rates it has been around only 55bps so far absolute. And only 20bps relative (over and above the US). So it is rather small. Of course the change in yields are much more and in the reverse direction. This is because the portfolio impact of QE is much stronger in the Eurozone than the US (given the outstanding amount/ composition and holders. See here). But yield compression is hardly the primary target.

In fact if we look at the real rate (instead of inflation expectation, as above), it is even worse for the ECB. Since Jan it has barely recovered the real rate tightening seen last half of 2014 in the Euro area. In the right direction, but nothing to celebrate.

Far too early to declare victory in for ECB. What we have seen is just front running by the markets with a very positive reaction. It was a real determined and confident policy move, and in Europe, such moves are rare, and are always appreciated by markets. Real economy still to catch up.

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