Article / 03 October 2017 at 8:00 GMT

Macro Outlook: What the ECB's ultra-loose policy has done to markets

Head of Macro Analysis / Saxo Bank
  • 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). 

Leaning Tower of Pisa

 Of all the PIGS (Portugal, Italy, Ireland, Greece, and Spain) economies, Italy's economy looks the most precarious. Photo: Shutterstock

So, in theory, if the ECB’s numerous policy measures worked, nominal GDP would increase sharply. The graph shown below (Velocity and Monetary Policy) plots the slope of an equation, where velocity is explained by the monetary base. The results are interesting: it turns out that the constant is 3.6, which is fairly close to average nominal GDP in the euro area over the period, and the slope is -0.8, which means that when the monetary base is broadened, velocity contracts almost by the same proportion.

All that says the ECB’s ultra-loose monetary policy has had little effect on the economy and growth, as many economists think. The explanation is quite simple: commercial banks did not play their role as lenders to the economy. Monetary policy boosted bank reserves, but the banks failed to lend out the added reserves to households and companies that they perceived as risky. In addition, liquidity was directed to financial markets where ROI was attractive. The recent evolution in credit has been more positive in the euro area, but there are still gloomy spots, such as Italy, where lending is negative.

velocity & policy

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.

mkt cap/liquidity

So far, reaching the ECB’s inflation target has remained the most challenging part of the job. Only five EMU countries (Slovakia, Germany, Spain, Belgium and Austria), representing around 54% of total euro area  GDP, have attained inflation close to the bank's CPI target rate of just below 2%.


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. 

The trend has been sluggish in 2016 and the slight move upwards this year won’t be enough to push CPI to the appropriate level. Based on the weakening of our model and higher euro exchange rate (which reduces imported inflation), the ECB is unlikely to be able to fulfill its inflation mandate anytime soon. But it seems increasingly clear that this is no longer a concern of investors.


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. 

On this subject, what happens during pay rounds in Germany will be of crucial importance. If IG Metall, the country’s main trade union, manages to secure a 3% or 4% raise, that will be a very positive signal for inflation. However, in the long run, wage growth in the EMU will probably ultimately be limited by labour market slack. 

A recent study published under the heading "Assessing Labour Market Slack" in the ECB Economic Bulletin (Issue 3/2017) concludes that “despite a clear improvement in many labour market indicators, labour markets in most euro area countries – with the notable exception of Germany – appear to still be subject to a considerable degree of underutilisation.” Labour market slack is estimated to be around 15% (at the end of 2016), which will contain wage dynamics in the medium term and, therefore, complicates the ECB’s task.


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 major and undeniable success of the ECB was to stop speculation on PIIGS government bonds. The PIIGS weighted spread to Germany is currently at 1.8%, fairly close to the pre-crisis level, versus 8.3% at the height of the European sovereign debt crisis of 2011-12. 

It is no mystery that ECB policy normalisation constitutes a major risk for PIIGS, mostly for Italy since its economy is still struggling with a substantial debt burden, and political risk will certainly be on the rise due to the general election scheduled on May 2018. Monitoring the cost of funding for PIIGS will be key once ECB president Mario Draghi proceeds with his plans early next year, and it will influence the scale and speed of monetary policy normalisation.



  • 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.

European Central Bank in Frankfurt
 The ECB has done some things right, such as halting 
speculation in PIIGS government bonds. Photo: Shutterstock

— Edited by Clare MacCarthy and John Acher

Christopher Dembik is head of macro analysis at Saxo Bank

m7010306 m7010306
The yield on 10-year US Treasuries (2.33%) is now higher than the yield on European Junk Bonds (2.32%). Should be named Mission Accomplished.


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