Economists' roundtable on the euro zone
Lessons from America

Free exchange

Andrea Ferrero, of Oxford University, continues our roundtable discussion of how the ECB can help the euro zone. So far we have heard from Paul de Grauwe, who argued that the ECB should stop fearing German opposition to QE.

LAST WEDNESDAY the Federal Reserve announced the end of open-ended asset purchases. While the Fed’s balance sheet will remain large due to the reinvestment of the principal payments from asset holdings, the expansionary phase is now over.

Together with the previous installations, the latest round of purchases has taken the overall asset side of the Fed’s balance sheet near $4.5 trillion, about a quarter of American GDP. What would the effect of a similar programme be on the euro-zone economy if the ECB were to follow in the Fed’s footsteps?

Even abstracting from various EMU-specific feasibility aspects, whether political or technical, assessing the potential economic impact of such a programme is far from easy. In spite of the widespread use of QE programmes by several central banks, there is little agreement on how asset purchases affect the real economy.

Clearly, by buying long-term government securities in exchange for either reserves or short-term securities (which I will consider here as close—in fact, perfect—substitutes), central banks bid up their price. These operations, however, occur for a given composition of the private-sector portfolio. Presumably, such composition reflects the private sector’s preferences over the menu of tradable assets. Some theories supporting real effects of QE therefore postulate frictions in financial markets such that the private sector cannot completely undo central-bank interventions. In such an environment, the quantity of assets in the hands of the private sector affects the return (typically by lowering the term premium) and some forms of market segmentation induce changes in consumption and investment behaviour.

The direct evidence in support of QE is mixed, and the estimated magnitudes of its effects rather uncertain. The main problem is that we cannot simply look at market yields and realised macroeconomic outcomes. In the absence of a counterfactual (“what would have happened if the Fed had not adopted QE?”), it is hard to come up with precise numbers.

Empirical and theoretical studies should help overcome these problems. Roughly speaking, available estimates suggest that long-term interest rates fell by somewhere between 3 and 15 basis points per $100 billion of purchases, with the variation being driven by the type of assets involved in the specific programme. If we lump together agency debt, mortgage-backed securities, and long-term Treasuries, the Fed currently holds a little over $3.8 trillion in long-term assets, up from pretty much zero at the beginning of 2009. Therefore, a rather conservative estimate of the effects of asset purchases on long-term rates (say, 5 basis points per $100 billion purchases) would suggest that QE has lowered long-term rates in America by a total of just below 2 percentage points over about five years.

Obviously, the next big question is how much lower long-term rates affected real economic activity and inflation. The range of estimates here is even wider. In a study on QE2 with Han Chen and Vasco Cúrdia (summarised here), we find that $600 billion of Treasury purchases increased GDP growth by 0.13 percentage points and inflation by 0.03 percentage points. These numbers may seem tiny. However, our results are at the lower end of the spectrum in the literature. Additionally, once cumulated to account for the full expansion of the balance sheet, the effects of QE, especially on GDP growth, would not look so dismal.

One point that our research stresses is that the interaction of different unconventional policy tools is very important. Central banks typically engage in QE operations when the traditional monetary policy instrument—the short-term nominal interest rate—is at its lower bound. In such circumstances, a commitment to keep short-term interest rates low in the future (“forward guidance”) magnifies the effects of asset purchases. The reason is that, while its effects may be small, QE is likely to be stimulatory both on real activity and inflation. The central bank will then tend to tighten its policy sooner rather than later. To prevent self-defeating expectations of higher rates due to current policy, the monetary authority can use both levers (QE and forward guidance) to maximise the expansionary effects of its unconventional actions.

What can Europe learn from the American experience? The latest numbers put euro-zone GDP at about $13 trillion. If the ECB were to run a QE programme of comparable size to what the Fed did in America, it would have to purchase about $3 trillion in long-term securities, split between sovereign bonds, mortgage-backed securities and possibly other type of assets. Using American estimates as a benchmark, we could expect that long-term rates would fall by about 1.5 percentage points, GDP growth to increase between a half and a full percentage point, and inflation to increase by about a quarter of a percentage point.

A crucial part of such a programme would be a commitment to keep nominal rates low for the duration of the balance-sheet expansion phase. In this respect, while the impact on rates would probably be front-loaded, macroeconomic variables would probably benefit from a gradual pace of purchases.

QE would hardly be the solution to all problems in the euro zone. But in the current situation, an aggressive program of asset purchases, coupled with appropriate forward guidance, would most likely provide some relief to a stagnant economy in the short term, and buy some time for the necessary in-depth reforms to take full effect.

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