One Man’s Opinion: Will the European Central Banks Initiate QE?

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92835431Latest data from he European Union showed annual inflation rate in the euro-zone slowed further to 0.3 percent in July from 0.4 percent in the prior month. A combination of two factors –low import prices, which is a legacy of a stronger euro, and low food prices are pushing the euro-area into the low inflation regime, said Paul Donovan, Managing Director of Global Economics at UBS AG. However, at this point there is a low inflation problem in the eurozone, but not an outright deflation problem, he noted.

Asked if the low inflation problem compounded the low-growth problem as well, Paul said when low-growth combines with low inflation, the outcome is a toxic “low nominal gross domestic product.” That’s a problem because when it comes to the government’s fiscal deficits and debt management, the nominal GDP (sum of real GDP and inflation rate) matters, he explained.

Asked to suggest policy solutions, Paul said politicians need to get their act together. That means initiating structural reforms of the labor market and a “proper” banking union, not a half-hearted effort that is being witnessed currently.

One of the problems of European Central Bank President Mario Draghi is that the transmission mechanism – taking money from the central bank and putting it in the eurozone economy, is broken in large regions of the currency area. Policymakers need to get around that problem and ensure money flows through the real economy, he noted.

Asked if a full-fledged quantitative easing is the solution to circumvent the problem, Paul said it is unlikely to work. If the ECB initiates a proper quantitative easing, everybody needs to believe that the central bank will continue to print money until the objectives are met.

If the ECB announced a formal quantitative policy, nobody would believe they will carry on till unemployment levels fell to normal levels and inflation levels met the bank’s target rate. The conviction that the central bank will continue unlimited printing of money is missing and people think it would run till the Germans opposed any further easing. The ability to implement a proper quantitative easing is very limited, he argued.

German Finance Minister Wolfgang Schaeuble recently said the ECB has run out of road. Asked if he agreed with that, Paul said though he agrees with Schaeuble’s observation, he believes the German Finance Ministry should stay away from monetary policy matters. The last time they tried it in 1923, the result wasn’t good. The Germans should rather lead in structural policy reforms in Europe and initiate the banking union. Unfortunately, the reality on the ground is different, he noted.

Asked if the eurozone is starting to look more like Japan, Paul said there’s a big difference between the eurozone and Japan. In the 1990s, the small and medium-sized businesses of Japan went bust, which was a really big problem. SMEs in Germany or France are not facing bankruptcy, which reflects the natural dynamism in the economy and that is likely to prevent the eurozone from slipping into deflation, he noted.

Asked to explain the outcome if the “status quo” persisted, Paul said Europe will witness mediocre growth for some time. There are, however, political risks if the situation plays out for too long.

There was a surge in nationalism in most countries except Germany and it showed up in European elections this year. However, that situation is likely to change if Germany starts to witness higher levels of inflation. More anti-euro sentiment is likely to come through from the German middle-class if inflation rose while the ECB was still easing monetary policy, which could create further problems, he concluded.

You can watch the video here.

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