Eurozone QE: Mind the output gap



  • Eurozone output gap is highly correlated with core inflation
  • Slowing money circulation means QE is “pushing on a string”
  • Eurozone consumers unlikely to benefit from wealth effect

26 January 2015, London. Paul Marson, Chief Investment Officer at MONOGRAM Investment, comments on the correlation between the output gap and Eurozone core inflation, and how the benefits of QE will be offset by slowing money circulation: 

How effective will the new Eurozone QE be? Eurozone core inflation [the ECB has no control over food and energy prices] is highly correlated with the output gap [gap between actual GDP and potential GDP]. Therefore, to increase inflation (and avoid deflation), you have to increase GDP growth and close the output gap.

Graph 1: Eurozone Output Gap v Eurozone Core inflation

Monogram Eurozone Outpout 

However, QE is unlikely to close the output gap because for every 1% increase in the Money Supply from the ECB, there is an approximate 1% decline in the velocity of circulation of that money.  Put simply, Eurozone QE puts more money into the system but it circulates more slowly.  The net effect is that nothing changes. It really is pushing on a piece of string.

Graph 2: Correlation between % change in Eurozone monetary base and % change in monetary base velocity

Monogram Eurozone Monetary Base

So the real hope of QE seems to be that an increased monetary base will lead to higher asset prices (especially in equities), and people will feel wealthier and spend more.  The trouble is, consumers in Japan and Eurozone have low holdings of equities (unlike the US and UK) and hence are unlikely to benefit from a wealth effect.”