euro4In recent weeks, the debate on whether the ECB should embark on a broad based asset purchase program which would include governments bonds has become ever more intense. Weak economic data, low inflation readings and statements by several ECB officials about the willingness and ability to act if circumstances require imply that expectations about further action have grown. An additional factor is the imminent release of the new ECB staff forecasts on growth and inflation where for both a significant downward adjustment is expected. This could be a trigger for action at the next ECB governing council meeting on 4 December.

The intensity of the debate has much to do with the lack of clarity on the transmission mechanisms and hence on the eventual impact of government bond based QE. Some argue that such a policy would do more harm than good. Rates are already very low so the interest rate sensitive components of final demand have already had ample opportunity to react to declining rates. The fact that they didn’t (think of capital expenditures) shows that other factors are at play than the level of rates. In that case, what kind of a difference would the additional and probably marginal decline of bond yields make? An additional argument of the ‘don’t go there’ camp is that the decline in rates would weigh on the profitability of the financial sector and would make households worse off (lower income from their savings).

The ‘what are you waiting for?’ camp essentially emphasizes the impact of the balance sheet expansion on the euro (there is indeed a nice correlation between the relative balance sheet dynamics of the Fed and the ECB and the EUR/USD exchange rate). Another channel is the impact on confidence. The effect could be important: broad-based QE would be considered as a commitment to be successful and hence take out the tail risk. This would reduce uncertainty and boost spending. A way to assess this is to look at the implied volatilities of equity options. The Bank of England in its assessment of its quantitative easing policy reported that, based on the option-implied distribution around the FTSE100 index, investors had been placing much less weight on large downside risks after the start of the program, whilst acknowledging that international developments may also have played a role

In January this year, being interviewed at the Brookings Institution, Ben Bernanke quipped that QE doesn’t work in theory but does work in practice. Based on this assessment, perhaps we should stop thinking about the transmission mechanism altogether: it’s like a black box and economists struggle to shed light on it. Let’s rather focus on the distribution of outcomes by answering the following questions:

1. What are the up- and downsides of doing government based QE now? Admittedly, there is a negative impact on bank profitability and household financial income but this may respectively trigger an increase in bank lending and a shift towards riskier assets. Another consideration is political rather than economic. Indeed, it is quite likely that such a decision would not go down well in e g Germany, all the more so considering that the German Constitutional Court still has to come with an assessment of OMT. On the upside, I see the weaker currency and increased confidence as the key transmission channels. On balance the upsides should dominate.

2. What are the up- and downsides of not doing it now? Not acting now could reflect a belief that such a policy could be effective but that (on political grounds) it is preferable to try to avoid using it or at least hold off as long as possible. However, applying this policy at a later stage, when the environment would be far worse, could significantly reduce its effectiveness and hence require an even bigger balance sheet expansion. Not acting now implies taking a bet that it won’t be necessary for the ECB to buy government bonds and a commitment to buy even bigger quantities if the need would arise anyhow, i e if it turns out that the forecasts were too optimistic. It means this approach has no real upside but has clear downside risk.

3. What does ‘never ever’ imply? A flat refusal to go down the path of government bond based QE, not today nor tomorrow, would reflect a belief that the delayed effects of past monetary policy decisions, perhaps in conjunction with the recent impulse from lower oil prices, would be sufficient to bring the Eurozone on a faster growth path but also an acceptance that it will take many years to meet the inflation objective. It would mean low growth and low inflation for years to come. It would also trigger market disappointment, a temporary strengthening of the euro and bond spread widening because markets are pricing that ‘something additional’ will be done. This would lead to a tightening of financial conditions with a detrimental impact on growth and confidence.

To conclude, the transmission channels of quantitative easing may be a black box but the distribution of outcomes of the different policy stances is very clear. This facilitates policy choices.