By Frances Coppola
The 2012 crisis began with Greece facing debt default and exit from the Eurozone, while investors feared other highly indebted countries (e.g., Portugal, Spain, and Italy) would follow. If these countries had still had their own currencies, investors’ fear of debt default would have caused their individual exchange rates to fall versus the dollar. But because they were all members of the euro, the euro’s exchange rate fell.1 This was accompanied by sharply spiking yields on government debt of the weakest countries, as investors feared those countries would exit from the euro and their debt would be redenominated in their much weaker individual currencies.
But the President of the ECB, Mario Draghi, promised to do “whatever it takes to preserve the euro”2 – and his promise worked. The euro’s exchange rate rose and bond yields fell. Although there have been two further crises in the Eurozone since that promise was made (Cyprus 2013 and Greece 2015), the euro has never again been in danger of breaking up.
After the 2012 crisis, the Eurozone suffered falling inflation,3 poor economic growth,4 and very high unemployment.5 To counter this, the ECB cut interest rates to unprecedented lows6 and provided large amounts of funding for Europe’s troubled banks.7 This proved insufficient: in January 2015, as oil prices slumped, the Eurozone entered deflation.8 In March 2015, after much debate, the ECB embarked on an Expanded Asset Purchases Program, more usually referred to as “quantitative easing” (QE).9
The ECB’s QE is thought to help the Eurozone economy through four principal channels:
How has QE worked in practice? Well, ECB interest rates have stayed very low.10 Yields on Eurozone government bonds have also fallen and in many cases are now below zero, especially for shorter-dated bonds.11 European stock and bond prices have risen considerably. And the ECB says that bank lending (“credit to the private sector”) has increased.12
The euro’s effective exchange rate rose steadily from the start of QE, which appears to suggest that the exchange rate channel did not work.13 But the ECB had done smaller-scale asset purchases before commencing QE,14 at which point it also signaled its QE plan15 – and the euro’s exchange rate fell significantly at that time.16 It may be that depreciation had already been “priced in” to the euro exchange rate by the time QE officially started.
More importantly, though, the Eurozone has at last started to recover. Although inflation is still some distance below the ECB’s 2 percent target,17 economic growth is picking up18 and unemployment is falling.19 How much of this is attributable directly to QE, and how much to other factors, is unclear. But it raises the prospect of an end to QE and start of interest rate normalization in the not too distant future.
The Eurozone’s brighter economic outlook is encouraging inward investment into the bloc, which influences the euro’s exchange rate. Since March 2017, the euro’s effective exchange rate has risen sharply.20
However, several countries in the Eurozone are still mired in recession and have fragile fiscal finances. Furthermore, the ECB’s “single mandate” says that it should conduct monetary policy so as to keep inflation “below but close to” the target of 2 percent per annum.21 Currently, inflation is well below this. Raising interest rates and ending QE would potentially reduce inflation still further, and prematurely ending the asset purchases that are keeping Eurozone government borrowing costs low could have unfortunate consequences for financial stability.22
In April, Draghi squashed suggestions that the ECB should start raising interest rates before ending QE. And in June, when the ECB’s policy committee discussed reducing the scale of asset purchases, stock and bond markets promptly fell, eliciting a comment from the ECB that investors had “misjudged” the message.23 In July, the ECB refused to set an end date to QE, standing by its earlier guidance that QE would continue at least to December 2017 and probably well into 2018.24 Despite growing economic confidence, therefore, the end of QE in the Eurozone still seems some way off.
Even when the ECB does decide to end QE and start reducing the size of its balance sheet, it is likely to proceed very slowly and cautiously. The U.S. Federal Reserve signaled the end of its own QE far in advance so as not to cause market disturbances, and raised interest rates before starting to reduce its balance sheet. It has now indicated that it will start to shrink its balance sheet “relatively soon,” but at an extremely slow pace: the Fed’s balance sheet may not return to its pre-crisis size for decades, if indeed it ever does. This is the model that the ECB will be looking at when it comes to unwind its own QE program. It may proceed even more cautiously than the Fed, because of the wide economic differences between various Eurozone member states and, therefore, the risk of financial crisis.
The euro’s strengthening exchange rate is driven more by expectations of renewed economic growth than by the prospect of the ECB ending QE and increasing interest rates. If the ECB withdraws stimulus slowly and carefully, there may be little or no effect on exchange rates. The euro’s effective exchange rate may simply appreciate gently as investment returns and growth accelerates.
With 17 years experience in the financial industry, Frances is a highly regarded writer and speaker on banking, finance and economics. She writes regularly for the Financial Times, Forbes and a range of financial industry publications. Her writing has featured in The Economist, the New York Times and the Wall Street Journal. She is a frequent commentator on TV, radio and online news media including the BBC and RT TV.
1. “Daily nominal effective exchange rate of the euro,” European Central Bank; http://www.ecb.europa.eu/stats/balance_of_payments_and_external/eer/html/index.en.html
2. “Speech by Mario Draghi, President of the European Central Bank, at the Global Investment Conference in London, 26 July 2012,” European Central Bank; https://www.ecb.europa.eu/press/key/date/2012/html/sp120726.en.html
3. “Euro area annual inflation and its main components,” Eurostat; http://ec.europa.eu/eurostat/statistics-explained/index.php/File:Euro_area_annual_inflation_and_its_main_components,_January_2007-July_2017-e.png
4. “National accounts and GDP,” Eurostat; http://ec.europa.eu/eurostat/statistics-explained/index.php/National_accounts_and_GDP
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7. “Monetary policy and the European Recovery,” Vitor Constancio, European Central Bank; https://www.ecb.europa.eu/press/key/date/2015/html/sp150530.en.html
8. “Euro area annual inflation and its main components,” Eurostat; http://ec.europa.eu/eurostat/statistics-explained/index.php/File:Euro_area_annual_inflation_and_its_main_components,_January_2007-July_2017-e.png
9. “ECB’s QE gets off to a flying start,” Telegraph; http://www.telegraph.co.uk/finance/economics/11463197/ECBs-QE-gets-off-to-a-flying-start.html
10. “Key ECB interest rates,” European Central Bank; https://www.ecb.europa.eu/stats/policy_and_exchange_rates/key_ecb_interest_rates/html/index.en.html
11. “Euro area yield curves,” European Central Bank; https://www.ecb.europa.eu/stats/financial_markets_and_interest_rates/euro_area_yield_curves/html/index.en.html
12. “Monetary developments in the euro area, June 2017,” European Central Bank; https://www.ecb.europa.eu/press/pdf/md/ecb.md1706.pdf?49a3994bafb989aed2c0c5bcd4590227
13. “Daily nominal effective exchange rate of the euro,” European Central Bank; http://www.ecb.europa.eu/stats/balance_of_payments_and_external/eer/html/index.en.html
14. “ECB announces operational details of asset-backed securities and covered bond purchases,” European Central Bank; https://www.ecb.europa.eu/press/pr/date/2014/html/pr141002_1.en.html
15. “ECB could pump 1tn euros into eurozone in fresh round of quantitative easing,” The Guardian; https://www.theguardian.com/business/2014/nov/06/european-central-bank-1-trillion-euro-eurozone-quantitative-easing
16. “Daily nominal effective exchange rate of the euro,” European Central Bank; http://www.ecb.europa.eu/stats/balance_of_payments_and_external/eer/html/index.en.html
17. “Euro area annual inflation stable at 1.3 percent,” Eurostat flash estimate July 2017; http://ec.europa.eu/eurostat/documents/2995521/8121470/2-31072017-BP-EN.pdf/7685c97e-bc00-4c0b-b97b-f1e58fa8ebb8
18. “GDP up by 0.5 percent in both the euro area and the EU28,” Eurostat flash estimate for Q1 2017; http://ec.europa.eu/eurostat/documents/2995521/8026125/2-16052017-AP-EN.pdf/e25d3d40-54da-42b9-a1c0-ae1a623b6bbd
19. “Euro area unemployment at 9.1 percent,” Eurostat flash estimate July 2017; http://ec.europa.eu/eurostat/documents/2995521/8121455/3-31072017-AP-EN.pdf/0f6be2e7-2f29-4180-9dd6-2363c4668c3e
20. “Daily nominal effective exchange rate of the euro,” European Central Bank; http://www.ecb.europa.eu/stats/balance_of_payments_and_external/eer/html/index.en.html
21. “The definition of price stability,” European Central Bank; https://www.ecb.europa.eu/mopo/strategy/pricestab/html/index.en.html
22. “The Politics of Ending Europe’s Stimulus,” Bloomberg View https://www.bloomberg.com/view/articles/2017-06-16/the-politics-of-ending-europe-s-monetary-stimulus
23. “ECB’s minutes stir debate over retreat from cheap money,” Financial Times https://www.ft.com/content/daf7fa60-622c-11e7-91a7-502f7ee26895
24. “ECB wary of putting end-date on QE,” CNBC; https://www.cnbc.com/2017/07/14/ecb-wary-of-putting-end-date-on-qe--sources.html