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The effects of Quantitative Easing on long-term interest rates
The European Central Bank has started its Quantitative Easing programme this month. The transactions involved are considerable (totalling some €60 billion a month) and concern bonds with maturities ranging from two to thirty years. The programme is to continue at least through September 2016. What kind of effect will these purchases have on long rates going forward?
In theory, two opposing effects are at work here. The first is a “mechanical” effect in which the ECB, by buying large amounts of bonds with long maturities on the market, causes their price to rise and, consequently, their yields to fall. This impact is significant because the amount of ECB purchases is considerable in relation to the total size of the euro-zone bond market. It is this first effect that has dominated movements in long rates on the markets in the last few weeks. The 10-year rate on German government bonds has fallen to a record low of 0.18%, while the equivalent rate has dropped to 0.44% in France, 1.12% in Italy and 1.14% in Spain. Meanwhile, the 5-year rate on German government bonds has slipped into negative territory.
Sources: Macrobond, BGL BNP Paribas
There is however a second effect that goes in the opposite direction. It is important to remember that the ultimate goal of Quantitative Easing is to boost medium-term inflation in the euro zone, moving them closer towards the ECB's objective of 2%. Inflation can be stimulated through a number of channels. First, historically low rates should stimulate credit and investment. Quantitative easing can also create wealth effects by driving up the prices of other asset classes. The surge in European stock markets in recent months in particular could lead to an increase in domestic demand, and consumption should also be bolstered by the fall in the oil price and the resulting rise in disposable income. Companies in the euro zone should benefit from a decrease in their financing costs, a decline in their energy costs and, for exporters, the fall of the euro. These factors together appear to be boosting the confidence of households and companies. That resurgence is vital for a sustained recovery in the euro zone, and recent increases in confidence indicators are particularly encouraging in this respect.
If Quantitative Easing turns out to be successful, economic agents should start to expect a more significant rise in medium-term inflation. At that point, inflationary expectations should be placing upward pressure on long rates to offset the fall in purchasing power caused by inflation. This effect contrasts with the mechanical effect described above. The key question for the bond market is at which point the second effect could begin to dominate the first.
BGL BNP Paribas
Published on paperjam.lu on 26 March 2015