Imagine a scenario where a market is losing value (deflation), which in turn scares away investors and greatly reduces cash flow in the active market. This stems growth, as more people lose confidence in a downward spiraling market. This is a scenario that the European Central Bank (ECB) would like to avoid, as the Eurozone is currently experiencing -0.1% deflation. Perhaps the ECB’s most important response has been through quantitative easing, which has had a substantial impact on the Eurozone's economy.
Quantitative easing is an economic policy where a central bank purchases public and private debt in the open market in order to fill the cash flow void that is crippling growth. As of January 2015, the ECB plans to spend 1 trillion euros through its quantitative easing program at a rate of 60 billion euros worth per month, until at least September 2016. This stimulus measure, geared towards reestablishing inflation and keeping it stable around 2%, has the ultimate goal of pushing the Eurozone out of the lingering recession.
Though it is still early, the strategy has been largely successful as the Eurozone inflation rate has increased by 0.3% and the Eurozone recently experienced a 46 month high in business activity. In March, the PMI composite increased to 54.1, signifying stronger expansion. Within their own economies, France and Germany experienced higher expansion across several industries. This has been possible because of quantitative easing, which has boosted investor confidence.
However, quantitative easing is also having a negative impact on the value of the euro and bond yields - both are extremely susceptible to volatility and have fallen since the start of quantitative easing. The combined elements can have a drastic effect as investors seek higher returns. With the smallest change in interest rates, which will undoubtedly happen as a response to the economic recovery, the yields on long term bonds denominated in euros will have huge swings. For instance, if a 30 year German government bond has a duration (length of time until investment is recovered) of 22 years, a one percentage point increase in interest rates will reduce the bond price by 22%.
Since the ECB’s quantitative easing strategy aims to fix the deflation issue by causing inflation, the long term yields theoretically should increase when interest rates increase. However, the major issue lies with investor confidence and patience as the quantitative easing strategy continues through September 2016.
Do you think the ECB’s quantitative easing strategy will help pull the Eurozone out of the recession or cause more trouble than what it stands to gain? Feel free to express your opinion with a comment below!