The ECB Pulls the Trigger on Stimulus

Posted by Brad McMillan, CFA, CAIA, MAI

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This entry was posted on Jan 23, 2015 12:36:00 PM

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ECBThe top story yesterday, at least in financial and investing circles, was the European Central Bank's decision to launch its own version of quantitative easing (QE). In short, the central bank will buy bonds in order to force down interest rates and encourage business investment and consumer spending.

A long-awaited (and much-needed) move

Getting to this point has been a slow, hard slog, with Germany resisting every step of the way. Even now, the QE program includes a limitation that holds national central banks responsible for losses on their own country’s bonds.

Nonetheless, this is a very big step. Europe has decided, finally, to stand up and largely unify financially to preserve the eurozone. More important, the program is not the usual minimalist approach: it’s larger and longer term than expected. 

What Europe needed was a real QE program like the one the Federal Reserve launched in the U.S., and what it got was very close to that.

Benefits for Europe and beyond

After some consideration, financial markets loved the plan. We can reasonably expect European markets and companies to benefit, and markets in other countries should see indirect benefits as well.

European companies will profit from lower borrowing costs and especially from a cheaper currency, making them much more competitive as exporters. European markets will benefit as the companies do. Plus, they’ll probably also get a boost as interest rates decline and a rising money supply lifts nominal asset values—just as we saw here in the U.S.

Markets elsewhere in the world will enjoy the same perks, albeit indirectly. There is much to celebrate in this program. 

So what’s not to like?

The real purpose of QE is not to inflate financial markets but to stimulate real economic growth. Here, there's more to worry about.

In my opinion, the Fed’s stimulus laid the foundation for U.S. recovery, but growth didn’t actually start until consumers began spending again—and, critically, when government moved away from spending cuts. When you look at the U.S. recovery, those were the two key factors. Fed stimulus and low rates helped set the stage for the recovery, but that wasn’t enough on its own.

In Europe, then, the stage is now set, but we’re still waiting for the actors—the consumers and governments—to show up. European governments are, by and large, still in austerity mode, which is a headwind, and employment remains in a coma, constraining consumer confidence and spending. Just as it did in the U.S., it could take years for the monetary stimulus to actually work its way into the real economy.

In fact, you could argue that’s a best-case scenario—that the ECB stays the course and continues to stimulate until the real economy comes back to life. The ECB has explicitly provided for a longer-term program, through September 2016, but it remains to be seen whether that will be long enough.

Moreover, the ECB’s action doesn’t resolve Europe’s ongoing political risks, such as the Greek election and potential repudiation of its rescue deal with the eurozone. And the situation in some countries, such as Germany, may actually get worse.

A positive step for the eurozone

Overall, the ECB announcement is good news, and much better news than many had expected. Of course, it’s only the first step on a long road, with difficult challenges ahead. But the journey of a thousand miles does begin with a single step, and this is a big one.

                                     

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