“This would be the context for a more broad-based asset purchase program.” So said ECB President Mario Draghi, about 2,620 words into a speech in the Netherlands last week. Spectators went into overdrive: Was this confirmation the ECB would finally launch quantitative easing (QE) to combat the “specter” of deflation? In our view, their hopes are misplaced for a variety of reasons. In reality, he was merely laying out the conditions necessary for the ECB to even consider quantitative easing (QE), and those conditions don’t match today. But if the ECB does launch QE, it very well could likely create the deflation everyone’s desperate to avoid.
Despite the many fears to the contrary, the eurozone isn’t in deflation. Prices are still rising—inflation has just slowed in recent months. The April flash estimate +0.7% y/y was up from March’s +0.5% y/y, but still well behind normal. Much of the weakness comes from falling energy prices—not a sign of actual deflation—but even core inflation, which strips out energy and food prices, is only at +1.0% y/y, still short of the ECB’s target.
Inflation and deflation are always and everywhere monetary phenomena—the broad money supply relative to supply and demand for goods and services. Usually, deflation happens when central banks suck money out of an already-weakening economy. That’s not the case today, with the recovery progressing and money supply growing, albeit slowly, at a +1.1% y/y pace. But the economy does face headwinds. In our view, a big one is also a big contributor to low inflation (lowflation?): Banks aren’t lending. Private sector loans declined for the 23rd straight month in March. The culprit? Upcoming ECB stress tests.
While US stress tests are largely a sideshow these days, in the eurozone, failing could carry major negative consequences. Banks that don’t pass likely have to raise capital. Assuming, that is, they’re allowed to continue existing—some officials have intimated failing a stress test could be equivalent to insolvency. It’s premature to say whether that’s the actual rule, as it depends largely on how the finer points of the Single Resolution Mechanism—the ECB’s procedure to resolve failing banks—turn out. But just in case, eurozone banks are hoarding cash and trying to minimize balance sheet risk.
Now that the European Banking Authority (EBA) has revealed the tests' parameters, it’s even easier to see why the banks are being extra-cautious. The test is extra tough! Conditions include a three-year long downturn sporting a -2.1% drop in eurozone GDP, 13% unemployment and an average -20% fall in house prices in the biggest eurozone countries. For comparison’s sake, during the last eurozone recession, GDP fell about -1.4% peak to trough, and unemployment peaked at 12%. And for housing prices among the biggest eurozone economies, Spain fell more than the stress test assumptions, but France and Germany held up far better.
The ECB, in its efforts to convince markets its exercise has actual teeth, has come up with something utterly unrealistic. How do we know? Buried in its methodology is the assumption underlying these expectations: That the end of quantitative easing causes a firestorm of a taper tantrum in Emerging Markets, which takes down the entire world—an irrational, media-driven fear. Banks are trying to run a business and create a gameplan based on their best expectations of future conditions. They do plan for the worst, but they at least try to ground that in reality. Last we checked, they typically don’t build business plans around media hype and hyperbolic, unrealistic doomsday predictions that have little grounding in history or economic theory. If they did, they might well never make a new loan ever.
It’s utterly confounding that banks could face such hefty punishment for failing this arbitrary, unrealistic exercise. But that’s the cold reality. Banks know it, and they have every incentive to do whatever they need to do to pass. For now, that means sitting tight and creating less money through lending—hence slowing inflation.
QE would exacerbate this and increase the chances of deflation. If the ECB begins buying up long-term assets to lower long-term yields, it would shrink the yield curve spread in the process. Banks borrow at short rates and lend at long rates—and the spread represents their potential profit. A smaller spread through QE gives banks even less incentive to lend. Why take the extra risk for so little reward?
This isn’t just hypothetical. The US’s and the UK’s QE programs wreaked havoc on lending and money markets. UK lending is still down, cumulatively, since QE began there. The US has had the slowest loan growth of the past six expansions during QE. M4 money supply (the broadest measure) fell for an extended period in both countries. It’s difficult to envision QE having a different impact in the eurozone. If the ECB compounds the stress test headache with QE, then they probably cause the exact problem they’re trying to solve: deflation.
Those calling for QE assume central banks can solve all of an economy’s problems—a fallacy. Central banks are all too often the source of problems, and the ECB would likely add to that list if they launch QE. A more beneficial tactic, in our view, would be to do nothing. Wait for the tests to pass, let the recovery continue, and look forward to the day banks are freer to play their usual role in the economy.
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