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18 Jul 2014

The eurozone’s road to QE

Janet Henry

by Janet Henry

Chief European Economist, HSBC

The eurozone is still struggling with too much debt, too little growth, a strong currency and the threat of Japan-style deflation. That’s why the European Central Bank (ECB) is still adding monetary stimulus when US and UK central banks are moving closer to the exit.

The ECB’s negative deposit rate, announced in June, had little immediate impact on the euro and the effects of the potentially more powerful targeted long-term refinancing operations will become apparent later in 2014. But with unimpressive economic data and inflation continuing to fall, investors still expect more stimulus – purchases of asset-backed securities (ABS) and quantitative easing (QE).

Quantitative easing would be controversial, less effective than hoped, and is not without risks

We expect 0.6 per cent inflation in 2014 and 0.8 per cent next year but the longer it stays so low, the greater the risk it feeds into expectations, encouraging cash-piling, delaying investment decisions, curbing hiring and lowering potential growth.

ABS purchases could happen this year but full-blown QE is 2015’s story, coming only after medium-term inflation projections have been lowered considerably – probably 1 per cent or less for 2016 – and assuming little or no pick-up in loan growth.

QE would be controversial, less effective than hoped, and is not without risks. Asset-price inflation has implications for financial stability and income inequality that governments and regulators must address with macroprudential measures and taxes. But the expectation of asset purchases has helped push down peripheral bond yields and driven the global hunt for yield.

So what economic events could take the ECB down a different policy track? Some alternative scenarios are positive for the real economy. If the policies already announced by the ECB work, growth and inflation forecasts would remain on track, requiring no further aggressive easing. Support could also be delivered externally, say by US companies spending their cash piles, delivering a strong investment recovery that accelerates US growth and expands world trade, including eurozone exports.

But other scenarios that could prevent or delay QE are much less benign. The Ukraine and Iraq situations have raised fears of an energy-supply shock. In a low-inflation world, rising energy prices would squeeze households’ real disposable incomes and corporate profitability, which would be negative for GDP growth, but even a temporary rise in headline inflation to around 2 per cent could delay further stimulus.

And within the eurozone, France and Italy have used May’s European election outcome to demand more flexible fiscal rules. The ECB would find it difficult to buy government bonds if some large member states were relying on that to fund larger budget deficits.

Despite these various risks, our eurozone GDP growth forecasts are unchanged at 0.9 per cent for 2014 and 1.1 per cent for 2015 with inflation predictions tweaked down to 0.6 per cent in 2014, then 0.8 per cent. However, we have raised our 2014 GDP German forecast from 1.7 per cent to 1.9 per cent and lowered Italy’s from 0.4 per cent to 0.2 per cent.

We have nudged up 2014 UK growth forecast to 3.2 per cent and advanced our first rate rise to February 2015, but still cut our inflation prediction.

We have also revised up growth forecasts and lowered inflation projections for some emerging European economies, notably Hungary, the Czech Republic and Turkey, despite further cutting our Russian forecast.

This research was first published on 7 July 2014.