Why European QE May Not Work

Key differences between the eurozone and the US could make the ECB's bond buying program less effective than the Federal Reserve's, says Morningstar's Bob Johnson

Jeremy Glaser 23 January, 2015 | 10:26AM
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Jeremy Glaser: For Morningstar, I am Jeremey Glaser. After months of speculation, the European Central Bank finally announced their quantitative easing program. I am here with Bob Johnson, he is our Director of Economic Analysis, for his take on it.

Bob, thanks for joining me.

Bob Johnson: Great to be here today.

Glaser: So, let's start with the size of the program, a little bit bigger than some of the leaks from earlier this week. Can you describe what the ECB is going to be doing?

Johnson: Yeah. They will be buying investment-grade debt from throughout Europe and they will buy about €60 billion a month, starting in March and going through September of 2016 and even after that it can be extended more. So it's kind of an open-ended program at a pretty high amount. That €60 billion by the way translates into roughly $70 billion worth per month. And to give you some feel, the latest QE program out of the U.S. from the U.S Fed was about $85 billion a month and I don't think that made it quite to a full year of purchases and then it kind of – they started shrinking it again. So, it's clearly a large program, as large as almost the U.S. program, and more than expectations.

Glaser: Now, how is this program going to be administered? There is some talk about how the national central banks are actually going to be taking on some of the risks here. What does that mean? How it's actually going to work in practice?

Johnson: They haven't spelled out all the details yet and those are yet to come, and there is always a little bit of a devil in the details. But it looks like that some of the buying would be pushed down to the national banks, national central banks and then backstopped by the European Central Bank, but not all of that. So, it's not quite as open-ended and as easy as the U.S. program was, but I am sure a part of this is a mechanism so that it doesn't look like the ECB is just blanket buying debt from say Greece or whatever, that it has to go through a mechanism of that country buying and then backstopping it through the Central Back.

Glaser: Now, what's the purpose of this program? Is it really just inflation like they are talking about or do you think it has that broader role to try to revive the European economy?

Johnson: Well, the European Central Bank and most of the national banks in Europe are really – their central banks are different than the U.S. Central Bank. Their banks are all charged with one mission, 'to control inflation.' In the U.S. we have the dual mandate of employment and inflation. So, they've always got to be a little careful to couch it even if their intent is otherwise that it's all about inflation and they're saying it was negative 0.2% in December and given that it was a deflationary rate that they had to act because the goal was 2% and (also are interested in this) inflation and since it's under 2% that they needed to act.

The reality is that Europe's economy has been dreadfully slow that Union-wide the employment rates are like 11.5% versus well under 6% here in the U.S. just to give you some perspective. So, they are still in world of hurt and this program also has some hopes of stimulating the economy, but they probably won't publically say that.

Glaser: So, how successful do you think this program can be? We saw that in the United States QE seems to have been at least happening at the same time as economic expansion in the U.K. There was some success there. Jury is still out in Japan. Will this program actually be able to accomplish those gains?

Johnson: I am very, very skeptical, but certainly the mechanism will be way different than it is in the U.S. So maybe I am not grasping all the picture, but rates there are already very, very low and they don't have a big housing and a big auto market to stimulate, oh, gee, rates are a little bit lower, boy, we're going to race out and buy that car. In fact, even in the U.S. stocks and bonds went up because of the extra liquidity.

But even on that front, in Europe, the stocks and bonds aren't as widely held. People have pensions that are funded by the government, less individual stocks and bonds. So we are not going to see the wealth effect that was one of the key parts of the U.S. program. So they will be missing that.

On the other hand, the mechanism where this may work is that European bonds just become so unattractive that all foreign buyers sell everything they've got and then sell their euros, and then go invest in another country. What that does is drive the euro down and we've already seen it fall from $1.45 to the $1 all the way down to $1.15 earlier this morning. That's a huge move and that will make Europe more competitive and that will be the mechanism where this may work.

The question is what products do they have that's going to dramatically help and that's a little bit of an open question. Certainly, vacation and tourism is on the front end of all of that, but will that be enough to move the needle or create the kind of jobs that they really want to create over there? That's another question. Some of the details in this program are still a little foggy to me. So, I am not convinced that this is a truly open-ended program like the Fed programme was.

Glaser: Given how far euro has already fallen, in speculation of this program or in anticipation of this program, is there really a lot of room for it to go much lower?

Johnson: You know, what, in almost every – and especially in the U.S. which I am most familiar with, but even to a degree Japan and the U.K., the speculation – they have to prepare the market for this type of thing. They can't shock people and ruin all the dealers and instantaneously shocking on, have this big program out of the clear blue. So they kind of warm the market up to it.

In the U.S. case it was like kind of a three-month advance thing here. We've been talking about this, I don't know, three, four, five months. With all that everybody kind of builds it in already and then by the time they actually start doing the buying, interest rates are on the way back up again and I think that's going to happen again this time.

Glaser: Finally, what's the impact of this on the United States? Are we going to see any big impacts to the U.S. economy?

Johnson: There are kind of two schools of thought on that. One is that obviously with a stronger euro – or with a stronger dollar and a weaker euro that that's going to have a pretty negative effect on U.S. exporters and I think that's probably true. It will have some. But as I have said many times in these videos that Europe is only about 3% of our GDP and a lot of it's locked in the Boeing airliners and soybeans and stuff that aren't very economic dependents. So, I really don't see it being a huge hurt from there.

It's certainly to make overseas more of a headwind than a tailwind that it's been, but I don't think that's probably the biggest effect. I think probably it's a positive effect in keeping commodity prices low because of their slow economy. So that's a big positive for the U.S., but I do think that the strong currencies are going to hurt a bit.

One of the other things I have heard kicked around, another school of thought is that, boy, the U.S. markets are just going to jump because now these European assets are all unattractive because of the low rates and money is the ultimate fungible commodity. So, they'll borrow from European banks and where is the best economy in the world right now, well the U.S., and so there will be – our stock market will be the beneficiary of that bubble, just in the same way when we did QE, emerging markets were bubbled up and this time around maybe it's the U.S. stock market. I am not so sure I'm entirely there, but that's one school thoughts that's out there.

Glaser: Bob, thanks for your analysis today.

Johnson: Thank you.

Glaser: For Morningstar, I am Jeremy Glaser. Thanks for watching.

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Jeremy Glaser  is markets editor for Morningstar.com, the sister site of Morningstar.co.uk.