On Thursday, the European Central Bank has published Account of Monetary Policy Meeting. The largest topic that now is being discussed is Quantitative Easing (QE). It assumes purchases of European bonds, mostly governmental. The mechanism works by the indirect influence on the overall interest rate level through lowering the yield of government bonds.


Base money M0 in Euro area (millions of Euro)

We all can understand how quantitative easing works, recollecting our lectures in macroeconomics.The Central Bank buys bonds from banks and increases demand on them, which leads to appreciation in price. The increase in bonds’ price means lowering the interest rate, and this effect should transpose to the whole economy. The difficulty is that the demand for bonds is already very high, because banks see too high risks to invest in the private sector, so for the central bank it is too unprofitable to buy bonds with an almost negative interest rate.


Money suppy-demand equilibrium increases

As we know, the monetary base M0 increases when central banks issue more money to shift the LM curve to the right in the ISLM model. Increasing M in money demand−supply equilibrium condition
L = M/P increases money demand, and the LM curve shifts. Ideally, we assume a movement along the IS curve, which represents all equilibriums in the goods market, to the lower interest rate, which relates to a higher GDP level. Therefore, we can expect the third significant increase in M0, which is represented by the red graph.

As ECB Quantitative Easing package shows, they are planning to buy government bonds for €60 bn a month during the whole program. This significantly exceeded market expectations despite some insiders noted that this amount would be €50bn monthly “because purchasing more assets sooner would “accelerate the impact” of QE.” Moreover, this program will go in addition to previously introduced methods of fighting small amount of new credits and the growing threat of a deflationary downward spiral.
The previous instrument ECB used for lowering borrowing interest rates was TLTRO, Targeted Long−Term Refinancing operations. It was a program of cheap long−term loans at the interest rate of just 0.15% to the largest commercial banks. These loans could be issues to businesses and households for 4 years or even more, if these are successful project, but cannot be given to purchase the real estate to avoid another realty bubble as in 2007. This program has been partly successful. The Governing Council of the European Central Bank notes that “The targeted longer-term refinancing operations (TLTROs) had contributed to a further decline in bank lending rates across the euro area, thereby easing borrowing conditions for firms and households.” However, everyone agrees that the expectations of banks’ desire for more liquidity have been overestimated: “The total estimated take-up over all eight TLTRO operations was significantly lower than envisaged in September 2014.” The first transfer in September 2014 resulted in taking loans of €82.6 bn, and in December €129 bn were allocated. Despite that, the total amount of €212 bn is very far below the initial 400 billions that were expected to be taken by banks in 2014. Many experts agree that the modest cheap loans’ appetite is the main reason of the dramatic change in ECB policy, which include QE of such a scale – ECB has not reached the expectations of lowering interest rates in public sector, and has now decided to operate independently from commercial banks, using the mechanism described previously. This situation cannot be called positive for the economy, because it was expected that the full amount of TLTRO will increase GDP of western European countries approximately by 0.3%.
At the moment the real GDP of 2014 is still being counted, although estimation can already be called as very accurate. ECB is almost sure that the European economy has expanded by 0.8% in 2014, and makes forecasts for the upcoming years. It builds it policy assuming the real GDP growth at 1.0% in 2015 and 1.5% in 2016, which was announced in Account of Monetary Policy Meeting. We should remember that these estimations already include the massive QE and assumption that the appeared difference in interest rates won’t remain solely in MFI (monetary and financial institutions) – the banking sector which we know from macroeconomics lectures as the second column of banking hierarchy, but will transfer its impact to “the society”, which is represented by the third column. If it happens, we are supposed to see the inflation rate above 1.5% in 2016, which is what ECB expects to be the healthiest for European economy by meaning “close to 2%, but not higher”. Frankly, now even the best economists can say how the quantitative easing will be successful in Europe. The forecasts of the public and private sectors are almost equal today, but both of them assume the highest uncertainty for previous years, so today the best decision is to act prudently based on forecasts, in other words – wait and see!