by Thomas Cooley, Charlie Nusbaum, and Peter Rupert
Much has happened since our last post. The US-China trade war intensified as the Renminbi was allowed to fall 2% in three days, the European Central Bank set rate targets deeper in negative territory, and a new quantitative easing program was announced with a bond purchasing target of €20 billion per month.

Moreover, the ECB staff projections suggested a worsening of the overall EU economy. The GDP growth estimate for 2019 was dropped to 1.1% from 1.2% and for 2020 from to 1.4% to 1.2%. Inflation forecasts are 1.2% this year, 1.0% in 2020, and 1.5% for 2021.

There was significant dissent among the members over the sharp change in monetary policy. Governor Draghi’s decision provoked widespread dissent, and led the German member of the executive board to resign in protest. The committee also made it pretty clear that monetary policy alone will not be enough, quoting the report from the last meeting:

Finally, all members agreed that, in view of the weakening economic outlook and the continued prominence of downside risks, governments with fiscal space should act in an effective and timely manner. In response to the significant risks related to geopolitical factors, the rising threat of protectionism and vulnerabilities in emerging markets, policies other than monetary policy would be more effective and were better suited to address country-specific shocks. In this context, the Governing Council should communicate carefully so as not to create unrealistic expectations about the contingencies that monetary policy was able to address.

While many European economies seem capable of sustained fiscal stimulus, the vast majority are relatively small. Among the larger economies, only Germany and, to a lesser degree, the United Kingdom appear positioned to loosen their purse.

All of this begs several questions. How are the largest economies fairing? How effective is European monetary policy? What more can be done? Let’s dive deeper into these questions.

What do the data say?

Real GDP growth throughout the EU continued to decline during 2019Q2. Year-on-Year quarterly growth in Italy remains just above 0.0%, whereas French and German growth fell to 1.38% and 0.41%, respectively. The downward trajectory for Germany is particularly troubling given that it is the largest economy in the EU. Spanish growth also declined, albeit to a lesser degree, to 2.03% while growth in the United Kingdom remained steady at 1.22%. Growth in the EU has a whole declined to 1.37% from 2.26% this time last year. The decline in the Euro Area is even larger, from 2.26% to 1.15%.

While it is the case that some countries have experienced quite high year-on-year growth, it has been concentrated in the smaller European economies.

While the above pictures already spark alarm, the annualized quarter-on-quarter growth rates are even more concerning. Quarterly growth in the EU28 has fallen remarkably during 2019Q2, from 2.0% to just 0.7%. Much of this decline is driven by the two largest European economies: Germany and the United Kingdom. The annualized quarter-over-quarter growth rate for each was -0.30% and -0.77%, respectively. Both are large contractions.

Unemployment remains low across much of Europe. Indeed, the unemployment rate in Germany and the United Kingdom reached 3.1% and 3.8%, respectively, in 2019Q2. Still, the unemployment rate in the next three largest economies-France, Italy, and Spain-are some of the highest in Europe. The EU28 as a whole lags far behind the United States along this dimension with an unemployment rate of 6.3%. Euro Area unemployment is roughly double that of the United States, with 7.6% of their labor force without work.

Moreover, investment growth, as measured by changes in real fixed capital formation, has all but ceased in the United Kingdom. Spain is not far behind. Italian investment growth, partially rebounded since 2018Q4, also appears tepid. Despite serious concern in 2018Q2, both the EU28 and Eurozone have outpaced the United States, experiencing investment growth of 2.5%, 2.8%, and 1.9%, respectively.

Market participants seem to have recognized some of these signs of slowing and have adjusted their expectations for future growth downward. Here, we use the spot rate yield curve as a proxy for market expectations. Typically, a higher rate is demanded for long term bonds than for short term bonds. The reasoning is simple: Both the opportunity cost and risk associated with long-run inflation and potential default are greater for long times to maturity than for short term bonds. As pessimism about the immediate future grows, capital shifts from equities to long-term bonds in the hopes of riding out a potential recession and market rates fall.

Relative to the prior two years, the yield curve in the Euro Area has begun to flatten. Indeed, yields on bonds of almost all maturity lengths have decreased and turned negative as of 2019Q3. The largest changes occurred for long maturity bonds, with the yield on 30 year bonds falling over 1 percentage point over the past year. In contrast, the slope of the yield curve remained fairly steady between 2017Q3 and 2018Q3.

While the previous picture is quite striking, the Q3 yield curve remains steeper than that in the United States. Whereas the average slope between 1 year and 10 year, and 1 year and 30 year bonds in the Euro Area is positive, only the latter is true in the United States. Still, the degree of change displayed above highlights growing market concerns.

Despite maintaining a negative rate target since June 2014, Euro Area inflation has remained far below that in the United States and the ECB’s inflation target of 2%. In fact, there has been little movement in average Euro Area inflation since 2014Q1 with the exclusion.

Another complicating factor is EU-US trade relations. The polices put in place by the ECB have been putting pressure on the Euro.

What has the ECB signaled?

With target interest rates steadily falling and little adjustment in average Euro Area inflation, the threat of deflation looms large on the ECB’s decisions. Incoming ECB President Christine Lagarde has said as much in the past: “If inflation is the genie, then deflation is the ogre that must be fought decisively.”

The outgoing ECB President appears to agree. According to Draghi the open-ended QE policy will be functioning “as long as necessary to reinforce the accommodative impact of its policy rates.” This left the timing and size to be determined as the data pour in. This is more like “open-ended forward guidance,” that is, “What data will be the determining factors?” The stage appears set for even further monetary stimulus moving forward.

Historical Consequences of Monetary Policy

But to what degree has the ECB succeeded in the past? The rate cutting behavior of the ECB is designed to boost the economy through increased consumer spending and a rise in loans issued by banks. The link between monetary policy and consumer spending appears to have weakened in recent years. Indeed, household consumption growth has slowed in many economies.

Instead, households have increased their deposits. The ECB reports that deposits held by financial institutions has shown a consistent upward trend since 2010. This is in despite of gradual rate cuts by the ECB.

On the other hand, the loan channel of monetary policy has succeeded to a degree. While loans to non financial institutions have declined relative to deposits held, the situation has improved since target rates entered negative territory in 2014. Still, achieving even such modest expansion of loans has required rather extreme rate targets.

Moreover, the rate cuts during 2011 appear to have reduced overall systemic risk of the financial sector and the probability of large scale defaults. It is unclear, however, if this correlation has persisted since 2014. Despite continued monetary policy loosening, the chance of systemic default has changed little. The reductions in systemic risk suggested by the figure below can only tell us so much. We do not know if this reduction is artificial or a sign of a healthier financial sector. It could very well be the case that loose monetary policy is simply hiding inefficiencies and otherwise be poor performance.

Our Take

Aggregate growth across Europe has clearly slowed and market optimism has decline remarkably over the past year. Concern within the European Central Bank is certainly warranted. It is not clear, however, how effective loosening monetary policy further will be. Despite crossing the so called “zero lower bound” and entering negative territory, inflation remains well below 2% and household deposits are growing at their fastest since 2010Q1.

This failure of rate reductions is likely the cause of the ECB re-instating its quantitative easing program. Such a program is not without its own inherent risk. Evidently, traditional policy tools have failed and so it is not clear what effect new QE will have. The ECB will eventually need to reduce its balance sheet and offload its assets. Expanding its balance sheet either too early or to little effect will only exacerbate the pain of tomorrow. To us, a not so simple question must be answered: Has European monetary policy reached its limit?