Its a popular belief among economists that the USA and other countries, namely Japan and the United Kingdom, used quantitative easing or QE to help them from falling into a terrible depression. What exactly is QE and how does it work? Given Europe’s current situation will QE work for them?

Definition

QE as defined by investopedia is “unconventional monetary policy in which a central bank purchases government securities or other securities from the market in order to lower interest rates and increase money supply”. QE increases the money supply by giving financial institutions capital in an effort to promote increased lending and liquidity, thus promoting economic growth. When Government has exhausted all possible options, QE is undertaken to stimulate the economy.

Europe’s Crisis

In 1958 the European Union (EU) was established, and in 1999 the euro was crafted with a group of 11 countries which handed over full control of their interest rates to one central bank, namely the European Central Bank (ECB). This was done with the view of achieving exchange rate stability, as well as to provide easier access to the international markets. One of the drawbacks to the creation of the euro however, was that member states would lose control over their financial regulation and independence, a situation which over the ensuing years manifested into weaker economies running into serious financial problems.

In 2009, following the onset of the great recession which started in the United States in 2008, countries in Europe began to battle with their own demons of the recession – economies shrank, unemployment rose, budget deficits ballooned and borrowing costs spiked.

Countries such as Greece, Spain, Italy, Ireland, Portugal and Cyprus were among the worst affected and all required financial assistance as the euro area plunged further into depression.

In 2012, at the depths of the then termed “European sovereign crisis”, Greece defaulted on its sovereign debt and was on the brink of exiting the EU, consequently sounding the death knell of both the EU and the Eurozone. In response, the ECB President, Mario Draghi, declared that the bank would do whatever it takes to preserve the euro and almost immediately, the fortunes of the euro and the euro-zone began to improve. Greece got the “life support” it needed through the “troika” of lenders (European Commission, IMF, ECB) and remained in the EU, confidence in the currency was re-established, sovereign borrowing costs declined and growth in the euro area eventually returned.

QE & Europe

The euro area emerged from the 18-month long great recession in the last quarter of 2013 but growth has since been sluggish and inflation continued to creep well below the ECB’s target of just under two per cent.

Concerned about the risk of the euro-area falling back into recession and the threat of deflation, the ECB president urged individual governments to do more to stimulate growth in their countries whilst maintaining fiscal discipline. Following previous bouts of monetary stimulus and rate cuts, the ECB in June 2014 further reduced benchmark rates (even bringing its deposit rate below zero) and provided concessionary loans to banks to on-lend to the productive sector to bolster economic activity.

Despite the ECB’s efforts, growth continued to slow and inflation remained below the ECB target. Even with the introduction of restricted bond purchases by the ECB, inflation continued to disappoint and after 4th quarter 2014 inflation turned negative to -0.2 per cent, mostly on account of plunging oil and commodity prices and reduced inflationary expectations. The ECB president felt it was time to up the ante even more.

On January 22, 2015, Draghi announced that, given Europe’s current situation of slow growth and fears of deflation, it will be undertaking QE as a means of getting the union back on the path to economic recovery.

In March 2015, the ECB will commence asset purchases to the tune of 60 billion euros monthly (US $69 billion) until at least September 2016.

In addition to monthly purchases, the ECB has further reduced the cost of long-term loans offered to banks. The EU plans to buys bonds relative to the size of its member countries. Eligible debts will only be investment grade issues with maturities of two to 30 years. Countries such as Greece will not initially be a part of the QE (given concerns that the imminent change in government may derail Greece from adhering to its austerity program with the “troika”). As such the QE will not apply to Greece for at least six-months on condition Greece remains compliant with the programme.

QE, which ended in October 2014 in the United States, arguably worked. Growths in recent quarters have been strong, jobs lost during the great recession have been restored, financial markets are solid and the Fed is on the verge of its first rate hike since 2007, a sign that the ongoing recovery in the US is sustainable.

Whether QE works for Europe or not as intended will be one for the history books. However, having already thrown everything else at its disposal to combat the threat of deflation, the ECB was left with little option but to hurl “the kitchen sink” as well.

Financial markets have so far responded favourably to the launch of QE. Stock markets traded higher and bond prices (especially European bonds) rose.

Stocks and bonds should continue to improve, but headwinds may come from — (a) a Fed rate hike later this year which would exert upward pressure on interest rates and thus affect bonds in particular and/or; (b) a resumption of the sovereign crisis in Europe as a result of a new anti-austerity government in Greece.

If QE doesn’t work in Europe, I’m afraid nothing else will.

Eugene Stanley is Vice President, Fixed Income and Foreign Exchange Services at Sterling Asset Management Ltd. Sterling is a licensed dealer and provides financial and advisory services to the corporate, individual and institutional investor. Feedback: If you wish to have Sterling address your investment questions in upcoming articles, please e-mail us at: info@sterlingasset.net.jm or visit our website at www.sterling.com.jm

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EUROPEAN CENTRAL BANK in Frankfurt, Germany (PHOTO: AP)