ECB QE set up for disappointment

[January 20, 2015]  By James Saft

(Reuters) - Rarely has a major market event been as expected as quantitative easing from the European Central bank; rarer still has something been so likely to underwhelm.

Almost everyone expects the ECB to announce a full-fledged QE program at its Thursday meeting; even French President Francois Hollande, who told business leaders on Monday that sovereign bond buying, long discussed, would become reality. Markets expect the ECB to announce 600 billion euros in bond buying, according to a Reuters poll, while economists are assigning a 90 percent probability to QE.

Press reports suggest that the bond buying may be delegated to national central banks, rather than sitting on the ECB’s balance sheet. This tactic in part is intended to blunt criticism of QE from Germany and elsewhere and to dampen any suggestion that bond buying amounts to direct government monetary financing by the ECB. While perhaps offering a polite fiction that the euro project will continue apace, the idea that the risks of QE might not be shared among member states sends an unsettling message.

It is unclear if Greece would take part, a thorny issue given speculation that its Sunday election will set the stage for dickering over debt terms that could end in default or a euro zone fracture.

Indeed while the markets look at the threat of deflation and a recession in the euro zone and take QE as a given, opposition in Germany from the Bundesbank and government is still real.

Many investors took last week’s shock decision by the Swiss National Bank to drop its strict control of the euro/franc exchange rate as confirmation that the ECB would deliver a forceful program, one which would spur too much selling of the euro for the Swiss to handle.

Indeed driving the euro lower is one of the points of QE, as is driving risky assets like equities and corporate bonds higher. To meet those goals, the ECB is going to have to deliver a clearly enunciated, large and detailed plan.

With expectations high there is plenty of room for disappointment, and with it a rally, rather than the hoped-for fall, in the euro and fall in euro zone equities, all of which would be bad news for growth.

“The foreign exchange market needs an ECB QE package in excess of €500bln to be 'surprised', and there has been enough discussion both about the likelihood of 'bad QE' (i.e. QE with risk-bearing at a national rather than euro area level) to suggest that it will be hard to find new euro-negative news on Thursday,” Societe Generale strategist Kit Juckes wrote in a note to clients.

SAWING WITH A SCREWDRIVER

Beyond the issue of the size and composition of the program is whether QE is the right tool for the job at hand. Using a very large screwdriver to cut wood is only marginally more effective than using a modest-sized one.

For QE to work it needs to impact consumption via the wealth effect, as those whose stocks and bonds are made more valuable spend some of the proceeds. That’s almost certainly going to have a diminished effect in Europe compared to the U.S., partly because of a lower propensity to spend asset-based wealth and partly due to the very real uncertainty felt by asset owners in places like Italy and France. As for corporations, they are more likely to respond to government reforms and stimulus than monetary policy. It is very hard to see a capital expenditure boom on the back of QE.

And while QE will to a certain extent help corporations to borrow by making bond markets more generous, it does nothing to rebuild capital in the banking sector, upon which euro zone economic growth remains highly dependent.

Finally, it must work by driving down the euro, making a euro rally on Thursday bad news for the ECB.

Agreement and harmony over stimulus and reform would likely bring better results than QE, both in the long and short term. In the euro zone central banking is hard, but politics still harder.

The measure of the success of the enterprise, then, is dangerously close to being delegated to financial markets, putting the ECB in a position in which no sensible central bank ever wants to find itself.

The Swiss about-face demonstrated that central bank promises are highly conditional and power is limited, even where their ability to print money is not in question.

The ECB on Thursday may extend and expand on that lesson.

(James Saft is a Reuters columnist. The opinions expressed are his own)

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at [e-mail] and find more columns at http://blogs.reuters.com/james-saft)

(Editing by James Dalgleish)

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