Macro Outlook: What the ECB's ultra-loose policy has done to markets
- ECB’s ultra-loose monetary policy has had little effect on economic growth
- It boosted bank reserves, but banks did not lift lending to risky borrowers
- Expansionary measures have worked some magic in equity markets
- Reaching the ECB’s inflation target has remained the most challenging task
- Eurozone labour markets are prone to underutilisation
- ECB's big success was to stop speculation in PIIGS government bonds
- Low inflation should lead the ECB to be cautious in QE tapering
- The world has entered a cycle requiring low interest rates for a long period
- Main risk is that QE exit could put PIIGS, especially Italy, under stress
By Dembik Christopher
Now is a good time to review and assess the impact of expansionary monetary policy on growth and asset prices in the euro area, before the next meeting of the European Central Bank.
One way to do this is to go back to economic theory — in that case, the velocity of money. As every student of economics remembers, velocity can be understood as the amount of nominal GDP every euro of base money buys. It can be summed up by the following equation: V=PY/M, where V is velocity, M is the monetary base, and nominal GPD is written as the product of the overall price level (P) with real GDP (Y).
Of all the PIGS (Portugal, Italy, Ireland, Greece, and Spain) economies, Italy's economy looks the most precarious. Photo: Shutterstock
When it comes to equity markets, expansionary measures have worked some magic though the stimulus has had a more limited impact on the Euronext (please see the following chart) than on the US stock market mostly, because banking intermediation plays a more important role in Europe.
In most EMU countries, inflation is mostly driven by rising energy prices, as shown by our model of domestically generated inflation (DGI), as shown below. This model calculates the range of inflation in the euro area based only on domestic factors: GDP deflator, service prices and wage growth. Its main advantage is to remove from calculations the energy base effects.
A key component of our DGI model is wage growth. Austerity measures in the PIIGS (Portugal, Italy, Ireland, Greece, and Spain) nations and wage moderation in core countries severely limited wage growth in the aftermath of the global financial crisis. However, since 2014, a steady growth in wages has resulted from the economic recovery in the euro area. Although the current level is below its peak from 1998-2008, the ongoing trend can still continue for a while as a result of GDP growth, higher corporate margins and possible higher wages in Germany.
In terms of investment (construction excluded), the destruction of capital caused by the GFC resulted in a deviation from the long-term trend (as shown in the following chart).
However, since the end of 2013/early 2014, there has been a gradual catch-up which, to continue, must also be accompanied by tax incentives for companies to invest, as was the case in France with the deduction from taxable income of 40% of the purchase of new industrial equipment.
- The ECB has done a fine job avoiding the worst, but the implications of expansionary monetary policy for the real economy and asset prices are still complicated to estimate precisely since these are new measures (typically quantitative easing) that were implemented in a very particular context of structural change (demography, technology, debt).
- Although the trend in wage growth is more positive in Europe than in the US, particularly due to a positive trend in Germany, low domestic inflation in the EMU should cause the ECB to be particularly cautious regarding tapering of QE.
- The global economy has entered a new cycle that will require low interest rates for a long time, which seems to have been well understood by central bankers. As mentioned by economist C. Reinhart on the occasion of the 2017 Economic History Association's meeting: "low interest rates prevailed for decades after 1945, we are in a cycle like that one and not close to a 1971 moment yet".
- In the short and medium term, the main risk for financial markets is that the QE exit puts PIIGS on the verge of recovery again under stress, especially Italy which remains one of Europe’s weakest spots.