LSR Macro Picture

Global macroeconomic themes in focus

January 29, 2015

Danger zone
Greek political risks and falling euro-area prices have made investors nervous about
the European outlook. The ECBs aggressive QE programme should help, mainly by
depressing the euro and supporting inflation expectations. But ECB QE looks less
powerful than Fed/BoE versions and, by itself, will not deliver sustained recovery.
Chart 1: Euro-area relapse
GDP, %YoY

Euro-coin indicator* (RHS)

1.5

1.0

0.5

0
0.0
-2
-0.5

-4

-1.0

-6
-8

-1.5
92

94

96

98

00

02

04

06

08

10

12

14

Source: Eurostat, Bank of Italy. *Bank of Italy's real-time euro-area growth indicator

Viscous cycle
Investor focus has returned to the euro area, where economic growth has faltered
and consumer prices are now falling. Meanwhile, Syrizas election victory in Greece
has compounded political risks. But the region is not yet in proper deflation and
growth might improve in H2, supported by monetary stimulus and lower oil prices.

Trans-mission possible
Deflationary fears have forced a policy response, with the ECB announcing an
aggressive QE programme. The main benefits should come from the weaker
currency, though the central banks action should also support sentiment. Other
effects on wealth and broad money could be weaker than with Fed/BoE QE.

Greece frightening
While the Greek political situation is unlikely to trigger financial tensions on the
scale seen in 2011-12, it increases the risk of policy accidents. It also highlights the
medium-term political risks that secular stagnation in the euro area entails.
Monetary stimulus alone will not be sufficient to counter these threats.

Danger zone
After two years of neglect, everyone is talking about euro-area risks. The first
negative inflation print since 2009 has compounded existing deflation fears, while
Syrizas election victory in Greece and rising populism everywhere has reminded
investors about the unhappy state of euro politics. Meanwhile, GDP growth has
faltered, dashing hopes of an economic revival. Still, not all the news has been
negative. The collapse in oil prices has been the main force depressing consumer
prices and this should also provide a helpful boost to consumers real incomes. This
type of deflation, dominated by one category of the CPI, is less scary than media
headlines suggest. Though subdued, unit labour costs and core prices have been
stickier, which means the regions gradual slide into deflation isnt yet complete.
The ECB has also provided a reason for investors to stay constructive, announcing an
aggressive potentially open-ended QE programme. For the first time, the central
bank will buy large quantities of government bonds. This breaks the taboo over
monetary financing that has held back the ECBs policy response for more than two
years. The sovereign bond market is large enough to ensure the ECB can achieve a
material expansion in its balance sheet more than 1 trillion (10% of euro-area GDP)
by September 2016. This is smaller than the QE programmes other central banks
eventually adopted, but as a first round of stimulus it compares favourably. The Fed
and BoE started with programmes worth 5% of their GDP but ended up buying
several multiples of this. The ECB could eventually reach similar levels.
QE was relatively successful in the US and the UK but could prove less powerful in the
euro area. Europes financial system is based around banks rather than capital
markets, so the spillovers to the real economy should be more modest. Wealth effects
are also weaker in the euro area, reflecting smaller equity holdings and a lower
marginal propensity to consume. Finally, because banks hold a greater proportion of
sovereign bonds in the euro area, the ECB could end up buying more of these assets
from the banking sector, providing a smaller boost to broad money. Despite these
caveats, ECB QE can still be helpful for the euro area. The main benefit will come from
the exchange rate, which has already depreciated significantly. The open-ended
nature of the programme also improves the odds of it anchoring inflation
expectations, helping in the central banks battle with deflation.
We think ECB QE and lower energy prices will support modest GDP growth in 2015,
with inflation even on core measures remaining far below the ECBs target. But
the euro area needs more than monetary stimulus to achieve strong, sustained
recovery. Without a co-ordinated approach involving structural reforms, fiscal easing
and targeted debt forgiveness, the region will remain vulnerable to euro-negative
political shifts. The Greek crisis is merely the most pressing example of this.

LSR Macro Picture | January 29, 2015

1. Viscous cycle
Global investors have become more gloomy about euro-area prospects. In part this
was because they had become too optimistic about the outlook after Mario Draghi
halted the regions financial crisis in 2012. Many hoped this would herald the start of
an economic revival. Instead, growth has consistently disappointed and recent data
even suggest some deterioration (see front page chart). Against this backdrop,
deflation fears have become more pressing, as has the unhappy state of euro politics.

Sub-zero area
Euro-area deflation is something we have been warning about for a while. The
economy is operating well below potential, unemployment remains at record highs
and the IMFs deflation risk indicators, which we regularly update, have been
signalling a deflationary threat for at least 18 months. Still, the collapse in oil prices is
the main reason the euro-area CPI is now falling. Core prices and unit labour costs
have been stickier. While these underlying price trends are subdued, this is not (yet)
proper deflation, which requires persistent and generalized price declines.
Chart 2: Underlying euro-area inflation
Unit labour costs

Core inflation

percentage change on year earlier

6
5
4
3
2
1
0
-1
-2

92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14
Source: Eurostat, OECD. LSR estimates

Of course, it is possible that the collapse in energy prices could embed itself into euroarea wage and price expectations, causing a more dangerous deflationary spiral. But
without such second-round effects, euro-area inflation should return to positive levels
in early 2016. Meanwhile, falling energy prices should provide a useful boost to
consumer demand by ending the recent squeeze on households real incomes. This
should help to stabilize and possibly even strengthen euro-area macro data in H2.
The collapse in energy prices has also been helpful in forcing a more aggressive policy
response from the ECB. By dragging down the euro-area CPI and lowering marketbased measures of inflation expectations, it strengthened Mario Draghis influence at

LSR Macro Picture | January 29, 2015

the central bank. In January he finally won approval for an aggressive stimulus
programme, overcoming stiff and long-term opposition from some of his colleagues.

2. Trans-mission possible
The reluctance of some ECB officials to adopt QE, usually for fear of monetising
government debt and creating moral hazard, has kept the ECB consistently behind
the curve in recent years. Trying to delay this decision, the central bank was forced to
adopt a series of largely token measures symbolic rate cuts, negative deposit rates
and small-scale credit-easing that always fell short of what was required. So buying
government bonds, potentially without limit, marks an important turning point in the
ECBs strategy. Not only does it break a restrictive taboo, but it should also allow the
central bank to deliver a meaningful expansion in its balance sheet (Chart 3).
Chart 3: ECB balance-sheet expansion
Lending to banks.

Asset purchases

Other asset holdings

Total balance sheet

3500

projection

ECB 's assets, billions

3000
2500
2000
1500

With QE

1000
500
0
07

08

09

10

11

12

13

14

15

16

Source: ECB, LSR estimates

Size matters
The scale of the ECBs proposed intervention is encouraging. The central bank will buy
60bn worth of government bonds and private-sector securities each month. It will do
this until at least September 2016 or until it expects to meet its inflation target. Even
if we take the minimum of these conditions, this implies more than 1.1 trillion in
asset purchases. The ECB hasnt given details on how it will allocate each 60bn
between public and private assets but when asked about this, Mario Draghi hinted at
a 5/1 spilt. This means the ECB would buy around 900bn in sovereign bonds. It will
buy these according to the ECBs capital key, as Chart 4 shows.

LSR Macro Picture | January 29, 2015

Chart 4: ECB bond purchases by country

per cent of domestic GDP (RHS)

250

18
16

200

14
12

150

10
8

100

6
4

50

2
MAL

CYP

EST

LUX

LAT

SLV

LIT

SVK

IRE

FIN

POR

AUS

GRE

BEL

NET

SPA

ITA

FRA

0
GER

Source: LSR estimates based on ECB capital key and assuming all countries qualify

Worth 10% of euro-area GDP, analysts have been quick to point out that the ECBs
programme is smaller than that conducted by other central banks. The Fed and the
Bank of England (BoE) ended up buying assets worth 25-30% of their GDP. But it is
important to remember that those other programmes started out much smaller,
typically at 5% of their GDP. And since the ECBs scheme is open-ended, it could
eventually reach Fed/BoE scale.

QE transmission
Beyond size, the more important question is whether QE will actually work in the
euro area. QE has been a controversial policy wherever it has been tried and
economists are divided on the question of how successful it has been. (There are no
counterfactuals.) We have generally been in favour, arguing it has lifted economic
growth and helped to sustain inflation expectations. It should also be beneficial to
the euro area, though there are reasons to think ECB QE could be less powerful.
The QE transmission mechanism takes a variety of forms, including: (i) lowering
interest rates, particularly at the long-end, which can discourage savings and raise
spending; (ii) raising asset prices, which can enhance confidence and boost wealth; (iii)
swelling the money supply, potentially raising GDP and smoothing the deleveraging
process; (iv) lowering the exchange rate, making exports more competitive, and; (v)
demonstrating the central banks commitment to its inflation objective, putting a
floor under inflation expectations and halting a deflationary spiral.

Problems for ECB QE

LSR Macro Picture | January 29, 2015

fixed for the long term, so lower yields triggered significant mortgage refinancing
activity. This allowed households to cut their monthly servicing costs and free up
disposable income. But in the euro area, mortgages are often set on variable interest
rates (especially in the periphery) and corporate borrowing tends to be based on
short-term bank loans, which are more closely tied to bank funding costs.
Chart 5: OECD wealth effect simulations
euro area

US

0.35

percentage change in consumption from 1% increase in wealth

0.30
0.25
0.20
0.15
0.10
0.05

years since shock

0.00
0

+1

+2

+3

+4

+5

+6

+7

+8

+9

+10

Source: OECD Economic Outlook 2009

Wealth effects are also weaker in the euro area. The prospect of ECB QE has boosted
asset prices such as equities but this could bring more modest benefits for the real
economy than occurred in the US. OECD simulations, such as those in Chart 5,
illustrate this. The OECD found that euro-area wealth effects are typically around half
as powerful as those observed in the US. A Bank of England paper supports this
assessment, finding that a 20% rise in equity prices typically boosts euro-area GDP by
around 0.2-0.4%, compared with 0.4-1.0% in the US.
Chart 6: Net financial wealth
400

per cent of disposable income

300

250

200

150
US

UK

ITA

EA 3

FRA

GER

Source: OECD, LSR estimates

LSR Macro Picture | January 29, 2015

There are two main reasons why euro-area wealth effects are more modest. First, the
private sector holds fewer financial assets, so a given increase in asset prices has a
smaller impact on wealth (Chart 6). Second, European citizens have a lower marginal
propensity to consume form wealth. This is because in those countries were equity
ownership is significant, such as Italy, it is typically held by older, higher-income
individuals. Equity ownership among low/middle-income households and the young is
around half US levels and these are the groups that tend to have the highest
propensity to consume.
Chart 7: Government bond holdings
UK 2008
70

Euro area 2014

per cent of government bonds held by:

60
50
40
30
20
10
0
Asset managers

Non-domestic

Banks

Central bank

Corporate

Source: ECB, LSR estimates

A final reason to suspect QE may be less effective in the euro area than elsewhere
relates to its potential impact on the money supply. Central-bank bond buying is more
likely to swell broad money if it buys those bonds from outside the banking sector.
Buying from banks merely replaces one liquid asset on their balance sheets for
another. But if the central bank buys from non banks, it will create new deposits and
potentially set off a hot potato effect across the wider economy. Households and
businesses may try to pass on the deposit, raising aggregate nominal spending.
The ECB hasnt said who it will buy government bonds from but based on experiences
elsewhere, its actions will probably reflect the overall structure of bond holdings.
With more bonds in the hands of banks compared with, say, the situation in the UK,
this could mean a more modest impact on M3. Fortunately, the ECBs plan to buy only
those bonds with maturities greater than 2 years could mitigate some of this effect
this since banks are likely to be holding the shorter maturities. And, unlike in the US
and the UK, the ECB has set a negative interest rate on bank deposits. This may also
encourage banks to put their additional liquidity to work.

Main benefits of ECB QE

LSR Macro Picture | January 29, 2015

benefits, the most obvious being the impact of the weaker currency. The euros tradeweighted index has already fallen sharply in recent months, in anticipation of QE. At a
minimum, the ECB needed to validate those expectations. But the currency could
decline significantly further from here, especially if the Fed starts to raise interest
rates in the second half of 2015.
Chart 8: Euro effective exchange rates
Nominal

Real CPI adjusted

125
120
115
110
105
100
95
90
85
80
99

00

01

02

03

04

05

06

07

08

09

10

11

12

13

14

15

Source: ECB, BIS, LSR estimates

Chart 9: Euro-area export exposure

Total

per cent of GDP, current prices

45
40
35
30
25
20
15
10
5
0
GER

EA

POR

ITA

FRA

SPA

US

UK

Source: Eurostat, LSR estimates

The euro-area economies have always been sensitive to the exchange rate, which
explains why European policymakers have always been so obsessed with them. This
reflects greater openness to trade, with exports typically taking a larger share of GDP
than is common in other major economies. But some of this is intraregional trade and
may benefit less from currency depreciation. For example, when the euro depreciates,
France will not gain competitiveness versus Germany or Italy, though it may improve
its competitiveness against non-euro trading partners in those markets (e.g. vs

LSR Macro Picture | January 29, 2015

Chinese and Japanese exporters selling to Italy). Adjusting for intra-regional trade
reduces the benefits of the weaker euro, but certainly doesnt eliminate them.
On average, euro-area exports also tend to have a higher price-elasticity than other
major economies, meaning a given decline in the currency has a more powerful
impact on volumes. This is especially true in the periphery countries, which tend to
produce lower-value, relatively homogenous exports (Chart 10). But these countries
are also the most exposed to trade wars. If, for example, China reacts to ECB QE by
introducing its own large-scale stimulus of currency devaluation, this could damp the
export benefits of ECB QE, especially for the European periphery countries.
Chart 10: Price elasticity of euro-area export volumes
0.0
-0.5
-1.0
-1.5
-2.0
-2.5
-3.0

export price elasticity with respect to real effective exchange rate*

POR

AUS

SPA

FRA

GER

EA

IRE

NET

BEL

Source: Estimated by the European Commission

Reflation expectations
A final important benefit from ECB QE is that it could halt the recent slide in inflation
expectations. After all, this development isnt entirely down to oil expectations
started to decline well before energy prices collapsed. Investors didnt believe the ECB
would do what was required to meet its medium-term mandate. Aggressive, openended QE might address such concerns and restore credibility. There is evidence this
mechanism was powerful in the US, where the Fed kept inflation close to its target
during the recession despite high levels of unemployment and a large output gap.

3. Greece frightening
More broadly, the ECBs intervention should help to put a floor under investor
sentiment about Europe. It probably explains why markets continue to shrug off
potentially damaging political risks such as Syrizas victory in the Greek elections.
While it is true the vast majority of Greeks want to remain in the euro, Syrizas strong
anti-austerity stand sets them up for some difficult negotiations with the Troika. In

LSR Macro Picture | January 29, 2015

principle, a deal should possible. The EU promised to consider further debt relief once
the Greeks achieved a surplus on their primary fiscal position, their budget net of
interest payments. As chart 11 shows, they are now doing this.
Chart 11: Greece's fiscal position
Gross debt
200

Primary balance (RHS)

per cent of GDP

180

160
140

120
100

80

-4

60
40

-8

20
0

-12
95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14

Source: OECD

There is no question that with Greek debt at 180% of GDP, further debt relief would
be helpful. Syrizas demands are not ridiculous, especially as 70% of this debt is in
official hands. But while there are things the European authorities can do to ease this
burden such as extending maturities or cutting borrowing rates this falls well short
of the large nominal reduction in debt Syriza is demanding. We cant predict how
these negotiations will go, but clearly there is a risk of policy accidents in the months
ahead. Greek euro exit may still be a low probability risk, but it is not unthinkable.
Fortunately, ECB QE and its existing OMT provide a powerful short-term firewall.
Chart 12: Greek bailout programmes
Borrowed from euro-area authorities
250

IMF lending

billions of euros (per cent of Greek GDP in brackets)

200

(73.9)

150
100
50

(23.3)

(17.5)
(8.9)

(6.1)

0
Prog. 1 (May 2010)

Prog. 2 (March 2012)

Total

Source: IMF, LSR estimates

LSR Macro Picture | January 29, 2015

10

But ultimately the ECB alone wont be sufficient to safeguard the euro and prevent
future crises. This would require more than monetary policy it would need
widespread structural reforms, fiscal easing in those countries with the capacity to do
so (e.g. Germany) and a comprehensive debt forgiveness plan (applying to all overindebted countries, not just Greece). Without this, the medium-term economic
outlook remains rather bleak. And unfortunately, this would provide the perfect
environment for further political crises in the euro area.
At a minimum, the Greek situation is just the most extreme example of a much
broader political trend in Europe rising populism and growing dissatisfaction with
the euro (Chart 13). The lesson for European officials is that secular stagnation is not a
politically sustainable endgame for the euro crisis.
Chart 13: Growing euro-area dissatisfaction
2009
100

2014

percent of population who think the euro is 'good' for their country

90
80
70
60
50
40
Ireland

Greece

Spain

Portugal

Italy

Source: Eurobarometer survey, The Economist

Bottom line
The ECB has finally woken up to the prospect of deflation in the euro area and has
taken an important step to address it. While QE may prove less effective in the euro
area than in other countries, it should still bring important economic benefits
especially from the weaker currency. These, together with the impact of the recent
oil-price collapse, should ensure the economy improves later in the year. But for
strong, sustained recovery the euro area needs more than monetary easing and the
situation in Greece highlights the political risks the region is taking without a broader
policy response.

Dario Perkins
[email protected]
For a short summary of our views on the global economy click here. The next issue of the LSR
Macro Picture will be published on 12 February.

LSR Macro Picture | January 29, 2015

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