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ECB Can No Longer Duck the QE Question


Expectations High That ECB Will Start Buying Eurozone Government Bonds

The European Central Bank’s date with destiny is fast approaching.

With headline eurozone inflation running at negative 0.2% and expectations of future inflation sliding, the market’s belief that ECB President Mario Draghi will announce on Jan. 22 a program of sovereign bond purchases is now almost universal. The risk is that this ultimately proves disappointing.

So far, Mr. Draghi has worked wonders with words alone. But investors now expect him to write a check to match. Certainly, the Swiss National Bank ’s shock decision to scrap its currency cap is seen by many as a sign that the ECB is about to open its wallet in an effort to push its balance sheet—currently at €2.17 trillion ($2.54 trillion)–back toward €3 trillion.

If Mr. Draghi doesn’t announce government bond purchases, markets are likely to take it badly. Even if he does, investors might not get all the details they want on Thursday.

It isn’t clear that the ECB has yet solved the thorny practical problems involved with buying government bonds in the eurozone, or even how well quantitative easing works. Some argue that the U.S. and U.K. recoveries have been helped by QE. Both have averaged nominal economic growth of 3% a year since embarking on bond purchases, while the eurozone has managed 1.1%, Berenberg Bank points out.

Yet conditions in the eurozone today are quite different from when those two countries ventured into QE. Government yields were higher back then, and the U.S. and U.K. fiscal deficits were much wider than in the eurozone, implying that budgetary stimulus was being provided along with monetary firepower.

The eurozone financial system relies much more on banks than capital markets, making the efficacy of a market-based approach questionable. And the eurozone still suffers from structural barriers to higher growth.

In the eurozone, the mystery of QE is complicated by questions around its design. What does the ECB buy and in what quantities? How should credit risk be managed? One suggestion is that national central banks will buy bonds at their own risk. That might be acceptable to markets now but could cause problems in the longer term if a fiscal crisis re-emerges. Another option is to buy only triple-A-rated bonds, but that might hand unwarranted power to credit-rating firms and cause distortions. The risk remains of a compromise program that falls short of market expectations.

There could yet be political ructions too. The ECB will say that sovereign QE is a pure monetary-policy operation. But skeptics can argue it represents pooling of fiscal risk, something that the eurozone isn’t ready for politically.

At least one thing appears certain. In August 2011, when the ECB reactivated its now-mothballed Securities Markets Program, a crisis-era bond-buying facility, then-President Jean-Claude Trichet only alluded to purchases obliquely. This time, if the ECB is going to buy government bonds, the message should be delivered loud and clear.

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