On the ECB Plans for QE

The development of the US dollar against the major currencies remains one of the crucial factors for the price trends of precious and also base metals. Of course, the policy of the Fed is one decisive determinants of exchange rate fluctuations. However, the monetary policy of other major central banks is also an important component in the price discovery process in foreign exchange rate markets. In this past week, ECB president Draghi stepped up verbal interventions which failed to drive the euro weaker against the US dollar. However, the ECB prepares the blueprint for implementing quantitative easing. Once the ECB embarks on QE, the US dollar could strengthen, which would have a negative impact on metal prices.

As the ECB is the central bank of 18 independent countries, implementing a common quantitative easing policy is not as easy as it was for the Fed or the Bank of England. The ECB has to decide, how to split the amount of quantitative easing among its member countries. According to the online edition of a German weekly magazine, the ECB staff considers currently two proposals. The first one is to allocate the funds for asset purchases based on the share, which each national central banks hold of the ECB capital. This would imply that the ECB would purchase for 26% of the QE volume German bonds, for 20% French and for 18% Italian bonds. When the ECB introduced the outright monetary transaction (OMT) program, which was not used so far, the Deutsche Bundesbank complaint that this program would be a transfer program. This argument also played a role in the decision of the German constitutional court. However, the argument of transfers could now also be applied to this proposal. As the ECB earns interest on the bonds purchased, the profit resulting from QE will be distributed to the national central banks. But German bonds bear the lowest yields. Thus, countries with higher yields could rightly complain that they would subsidize Germany, which would profit from interest earned by the ECB on buying bonds of countries with a higher yield level.

Furthermore, allocating the highest share of QE funds for buying German assets does not make much economic sense. One should keep in mind, what the reason for QE is: namely to prevent deflation. Germany profited from the financial crisis in the Eurozone already by having the lowest yields in the Eurozone and by growing relatively strong compared to the rest of the Eurozone. The deflation risk in the Eurozone is the result of the wrong economic policy, which Germany pushed through at EU summits. If the ECB will decide to allocate funds for QE according to the share on its capital, then Germany would be the biggest winner again. Another argument against the highest share for Germany is that German companies already have lower funding costs compared with companies located in other Eurozone member states. They need less support from the ECB than others.

The second proposal is to allocate the funds according to the size of national government bond markets. In this case, the ECB would allocate 25% for buying Italian bonds and about 22% for French and German bonds respectively. This would make more sense because some countries with higher borrowing costs for companies compared with German entities would receive a bigger slice of the cake. However, from our point of view, this is still not an optimal solution.

The two proposals do not take into account the reason for QE. To prevent deflation, countries where the deflation risk is high should receive relatively more funds than countries with less deflation risk. Thus, one criteria could be the difference between the ECB target inflation rate and the actual inflation rate. As the ECB’s target is an inflation rate close, but below 2%, a good starting point might be the difference to 1.9% inflation rate. According the Eurostat, the statistical office of the EU, the harmonized CPI inflation in Germany is 0.9% in March 2014. Thus, Germany is 1.0% below target. However, in Greece, the inflation rate is the lowest with -1.9%, which implies that Greece is 2.8 percentage points below the target. In Cyprus, harmonized consumer prices dropped 0.9% from the same month one year earlier and in Spain the inflation rate was -0.2%. At the other end of the spectrum are Finland with +1.3% and Austria with 1.4%, which would need less monetary stimulus.

Another indicator of deflation risk would be the output gap. The risk of deflation is increasing, the more the actual output is below the potential output. Thus, countries with a bigger negative output gap should receive relatively more monetary stimulus than countries with a small negative output gap. Given the GDP development over the last few years, it is also not difficult to guess that the Southern European countries would need a relatively higher monetary stimulus than Germany.

It should be clear, that neither the difference between actual and target inflation rate nor the size of the output gap alone are a good weighting factor for the allocation of QE funds by the ECB. The size of the bond markets should also play a role because the financial markets have to absorb the volume of QE measures. What we would propose is a two-step process to calculate the allocation weights. In a first step, weighting factors would be calculated based on the inflation gap. In the second step, the size of bond markets would be multiplied with this inflation based weighting factor. The volume of QE would then be allocated according to the share of the weighted bond market size in relation to the sum of weighted bond market size over all member countries.