FRANKFURT – Europe’s economy could be sinking in deflationary quicksand. On Thursday, the European Central Bank is expected to throw it a rope — in the form of massive purchases of government bonds using newly printed money.
The step, known as quantitative easing, or QE, is considered a last resort in the bank’s effort to pull the economy out of stagnation that could ultimately threaten the currency’s existence.
Here are some basic facts about QE — and what it might mean for the global and U.S. economies.
Q: Why purchase a boatload of bonds?
A: To raise the rate of inflation. Right now inflation in the 19 countries that use the euro is so weak at minus 0.2 per cent annually that there is concern the eurozone could slide into chronic deflation, and experience the long-term stagnation that can come along with falling prices. That’s what happened to Japan in the 1990s — and they’re still trying to climb out. The ECB is way off its inflation target of just under 2 per cent. It has tried a slew of other stimulus measures to boost prices and growth, including cutting its benchmark interest rate to just above zero, at 0.05 per cent.
But the inflation rate has continued to fall. The eurozone is still working off a crisis over too much government debt, and austerity has held back the recovery. Unemployment is at 11.5 per cent, and at 26 per cent in Greece, which is still recovering from a severe financial crisis. Money market indicators indicate longer-term inflation expectations remain weak. So now the bank is down to what is considered its most drastic tool. Analysts predict the bank’s 25-member governing council will make the decision Thursday at its headquarters in Frankfurt, Germany.
Q: How do bond purchases work?
A: The central bank pays for the purchases — and creates new money — by simply increasing the amount in the reserve accounts banks are required to have at the ECB. It’s a trick the central bank can use because it’s the currency’s legal issuer under the basic European Union treaty.
Q: How do the purchases affect the wider economy?
A: Purchases increase the amount of money in the banking system, meaning there is more to lend and invest. That can make credit easier to get and drive down rates. As that happens, they can increase the amount of money in the economy, boosting inflation. The purchases also drive up bond prices. That drives down their interest yields, since yield and price move in different directions. That makes borrowing cheaper in the bond market as well for governments and companies.
Q: What does this mean for investors, businesses and consumers?
A: One of the most important results is expected to be a lower euro against other currencies. That will help boost inflation and eurozone exports. The euro has fallen to $1.16 from just under $1.40 in May on anticipation of QE. The weaker euro means cheaper European vacations for Americans. But it can trim European profits for U.S. multinational companies for earnings purposes, making profit goals harder to achieve.
QE can also push up prices of financial assets beyond bonds, such as stocks. But the overall goal is to get the economy moving — and that’s important for people all over the globe. The eurozone is a major trading partner with the U.S., Eastern Europe, Britain, and Asia. A weak Europe can cost jobs and profits elsewhere.
And, though there are no provisions for leaving the euro, even EU officials say long-term stagnation is an obvious loser among voters. If the euro is going to survive, it has to thrive.
Q: How much will the ECB buy?
A: Several analysts say 500 billion euros ($580 billion) is a likely figure though analysts at UBS say as much as 1 trillion euros is possible. If the market thinks the amount is too small that might limit the impact.
Q: If the Federal Reserve, Bank of Japan and Bank of England have all done this, why is the ECB only now getting around to it?
A: QE has been opposed by officials from Germany and other eurozone countries such as the Netherlands. They say any losses on defaulted bonds could be transferred to their taxpayers. There are also concerns QE will have less effect in Europe in part because bond prices have already risen so much.