As we highlighted in our 2015 outlook piece, there are significant differences between how we should expect QE to benefit the real economy in Europe relative to how it benefited the economy in the U.S. In the latter case, the benefits from what Draghi called substitution (and what the Fed calls the “Portfolio Rebalance Channel”) are limited to just the lending impacts he describes. As such it is hard to imagine, given the ample liquidity support and incredibly low (and negative) interest rates already entrenched in Europe, how expanding QE will lead to further real economy benefits from this channel. In the U.S. those further benefits crucially flowed through the wealth effect channel: substitution of lower risk assets such as bank deposits and Treasuries for high yield bonds and equities led to price increases in those risky assets. That broad based asset inflation, including critically the intended recipient house price inflation, led to rising consumption, a pattern well entrenched in the U.S. economy.
Such a relationship has no basis in the European economy (and as we pointed out in our outlook piece, in the case of Germany actually shows some evidence of the opposite of the intended effect, as rising wealth is associated with rising savings rates and reduced consumption). Hence the main and, per Draghi, unintended transmission mechanism to the real economy lies in the currency. Since it’s unacceptable for global central bankers to directly target the currency as a policy tool, Draghi refers to the currency impacts as effects of the policy, not targets.
That leaves fiscal policy and structural reforms as the critical and necessary next steps to support economic recovery in Europe. But those steps require political will and hard and risky choices for democratically elected leaders facing an increasingly euro-skeptical and polarized electorate. Which brings us to the ECB’s QE paradox: in such a political environment, only significant market or economic pressure can bring governments to make such difficult decisions. A clear mandate of governing majority is required to undergo such a politically fraught exercise. Even in the case of Japan, where arguably Abe has such a political opportunity, he still faces entrenched opposition to imposing his “third arrow” structural reforms.
Today’s low public opinion of Europe’s governments suggests few would or could be expected to follow this path. And absent the bond market pressure that Draghi has so successfully done “whatever it takes” to ensure it never to return, the very action of QE reduces the likelihood of governments undertaking the reforms Draghi so repeatedly calls on them to take.
Jeffrey Rosenberg, Managing Director, is BlackRock’s Chief Investment Strategist for Fixed Income, and a regular contributor to The Blog. You can find more of his posts here.