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ECB bond-buying program is not a universal weapon against deflation — Coordinated monetary, fiscal, and structural policies are imperative

Press Release of March 25, 2015

DIW Berlin examined the preconditions and probable effects of the quantitative easing in the euro area, and compared it to similar programs in other countries. The bottom line: Although there is heavy pressure on the ECB to take action, monetary policy should not remain isolated.

According to the German Institute for Economic Research (DIW Berlin), the European Central Bank’s (ECB) asset purchase program alone is not enough to avert the risk of deflation in the euro area and end the crisis. The study concluded that "there is heavy pressure on the ECB to take action. But monetary policy measures should not remain isolated. We need monetary, fiscal, and structural policies that are coordinated and aligned with sustainable growth in the entire euro area.“ To assess the chances of success of the ECB's program, DIW experts Kerstin Bernoth, Philipp König, Carolin Raab, and Marcel Fratzscher analyzed the current inflation developments, as well as some of their underlying causes in the euro area, and compared the ECB’s program with similar programs in the United States and Great Britain. Moreover, even after a detailed examination of the various transmission channels of such a measure, the precise impact of the ECB's program was, however, difficult to assess. According to the study’s authors: "With its quantitative easing, the ECB is venturing into uncharted territory."

In January 2015, the inflation rate within the euro area fell to its lowest point since the introduction of the common currency. As measured by the Harmonised Index of Consumer Prices, it stood at minus 0.6 percent compared to the previous year. Hence, the ECB is clearly failing to achieve its mandate of price stability. Pending a sustainable correction of the inflation trends, the ECB therefore embarked on a large-scale asset purchase program, and started to buy bonds from the private and public sectors amounting to €60 billion per month. This program is set to run until at least September 2016. Nevertheless, financial market participants are, for the most part, not expecting the inflation rate to return to the ECB's inflation target of just under two percent in the next three to five years. The causes of the weak price development are manifold, according to the DIW analysis. "The sharp drop in oil prices is playing a major role. But other essential factors include weak demand and the relative price adjustments that the crisis-stricken countries in particular need to make in order to regain competitiveness, as well as the ongoing reduction of the debt overhang, which continues to take precedence over investments for many households and businesses. This macroeconomic adjustment process and the resulting price pressure are likely to persist." Indeed, the weak price development in recent months has put the ECB under strong pressure to act, however the causes of weak price development can only be partially influenced by monetary policy alone.

Low interest rates are problematic

Some countries have already had experiences with such QE programs. In the US and UK, interest rates declined directly after the announcement of the program—or, to be precise, with the start of the purchases. Delayed effects were still only minor then. "There are strong indications that the program primarily takes effect with the announcement and the signaling channel," concluded the DIW experts. In the euro area as well, the announcement of the program has raised inflation expectations and contributed to a depreciation of the euro. The announcement had only a minor impact on interest rates, however.
Since the interest rate level in the euro area is already very low, only limited additional interest rate reductions are expected.

Although the announcement of the program has already shown some effects, it is as the sole economic policy measure not sufficient to ward off the economic crisis and the threat of deflation within the euro area. Therefore, the DIW experts also argued for increased coordination of fiscal and structural policies of the monetary union and concentration on new economic growth.

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