Written by Brandon Luu, GEI Associate
A week ago the European Central Bank announced action to combat low inflation and stagnant growth in the Eurozone. ECB President Mario Draghi announced several measures to be taken. Interest rates were cut across the board with deposit rates cut to -0.1%. It had been widely anticipated that deposit rates would move into negative territory as part of an overall plan to ease liquidity. In addition, the central bank is also working on a program to directly purchase asset-backed securities, a more aggressive move than rate cutting.
President Draghi announced that he will suspend sterilizations of bond purchases under the Securities Markets Program. Ending sterilizations means money that would be sterilized now remains in the banking system. The hope is that banks with excess funds will lend to other banks. As a result, short-term interest rates decrease, leading to increases in loans to households and businesses. In addition, it raises expectations of future quantitative easing from the ECB.
Figure 1: Sterilized Intervention, which has been suspended by the ECB
Assuming interest parity R = R* + (Ee – E)/E:
A sale of domestic assets from A to A’, or sterilization of foreign asset purchases is represented by R* + (Ee– E)/E + r(B –A) where r is the risk premium that reflects the difference between the riskiness of domestic and foreign bonds and B is the stock of domestic government debt.
Sterilization increases the required return of the domestic currency, causing the currency to depreciate.
Although Draghi has not taken a firm stance on whether QE will be the next step, he indicated that more action will follow in regard to the market for asset-backed securities. These initial measures are a step in the right direction, as it is widely agreed that the ECB needed to be more aggressive in its policies. However, whether these measures will last temporarily or be a long-term solution is still in question. The inflation forecasts for 2015 and 2016 of 1.1% and 1.4% are also in doubt. The forecasts still fall below the target rate of 2% and it is uncertain whether the programs will create enough inflation to meet those forecasts. Even several periods of QE did not generate high inflation.
If the inflation outlook deteriorates further in the coming months, a broad-based asset purchase program such as QE seems to be the only remaining option as interest rates have already been cut to record lows. The desired effects of this policy can be illustrated using the IS-LM/AD-AS model, focusing specifically on the LM and aggregate demand curves. When the ECB purchases assets, money is injected into the economy, increasing money supply and shifting the LM curve to the right. Expected inflation causes demand for money to fall, also causing a rightward shift of the LM curve. As a result, the AD curve shifts to the right. These shifts illustrate increases in output and employment.
With the demand for money falling because of expected inflation, wealth-holders attempt to exchange money for non-monetary assets, driving up their prices and decreasing the real interest rate. This increases consumption spending as well as investment spending. With greater demand for output in the short run, firms must increase production and employment, which would achieve the ECB’s desired result. The implementing of such a program seems even more likely with Germany’s Bundesbank shifting from its traditional opposition to ECB policy measures. With limited remaining options and possibility that the inflation outlook could worsen, Germany’s central bank has become more willing to support non-conventional measures. However, it is difficult to predict what the appropriate course of action is without assessing the effects of the current measures, especially since empirical data often differ from theoretical models.