Just three numbers are enough to get the full picture: 0.25; 0.50; 1.2 . The key intervention rate, or “main refinancing operations of the Eurosystem” as it is officially known, stands at 0.25 percent since last November—indeed very close to zero. Inflation in the euro zone runs at 0.50 percent, significantly lower than the two percent official target set by the Bank. And estimated growth for 2014 is optimistically set at 1.2 percent.
So the picture is a rather gloomy one. After several years of recession, Europe is shyly struggling to recover while the risk of a long-term deflation cannot yet be excluded. Christine Lagarde, the head of IMF has issued several warnings to this effect. Even worse, unemployment is so high in a large part of the euro zone that this modest recovery, if prolonged (the forecast for 2016 is 1.8), means that it will take long years before the average citizen sees any change. Indeed a modest performance if compared with an estimated 3.0 percent growth for the US and around 2.0 percent for the UK. Here enters the European Central Bank (ECB) in the picture.
Central banks conduct monetary policy through adjusting the short-term interest rates, in order to control the cost of money. But with interest rates around zero since the financial crisis of 2008, this channel is not operative. Still, there are other ways to intervene in the markets, the most powerful one being to directly control liquidity either through loans to commercial banks or through purchase of long-term securities, especially government bonds—this is the so called Quantitative Easing or QE. All major central banks did it: the US Federal Reserve started in November 2008, initially buying housing agencies’ securities under a program that became famous as Quantitative Easing 1 (QE1); then, in November 2010, it moved to QE2, buying treasury bonds, at a pace of 75 billion dollars per month; followed Quantitative Easing 3 in September 2012. All in all, the Fed bought around 2 trillion dollars during this operation, adding an equal amount of liquidity to the market. The Bank of England and the Bank of Japan did the same, but for lower amounts.
Following this trend, the European Central Bank’s chairman Mario Draghi announced a few days ago that the ECB’s governing council was ready to take radical measures to fight deflation, and there is nothing more radical than to buy government bonds. Analysts expect the euro zone central bank’s purchases of bonds to reach around 1 trillion euros, but this is pure speculation as neither the amount nor the date are yet known. Still, there are several technical problems in conducting quantitative easing by the ECB. Unlike the US Fed, which deals with only one sovereign issuer, the euro zone central bank has to deal with many; thus it has to find the right mix of securities, and take under consideration various levels of spreads and risks. Some of its governing council members insist to also include corporate bonds— a further complication, given that corporate bonds markets in Europe are rather illiquid. Finally, the purchases of bonds shouldn’t affect too much the euro’s exchange rate, whose strength is a a serious impediment for EU exports and growth.
On Draghi’s announcement, the spreads of South European bonds dropped significantly. More to that, Greece, euro zone’s more troubled economy, made a spectacular comeback to financial markets by floating a five-year bond at 4.75 percent and raised 3 billion euros; demand was overwhelming as the offering attracted more than 20 billion euros in orders. In sharp contrast to what the financial press was claiming two years ago, nobody speaks anymore of Grexit, nor of the euro zone’s breakdown.
The European Central Bank decided to buy bonds, finally. It’s been a long way since the outbreak of the crisis of 2008; Europe managed to create the necessary defense mechanisms to protect the common currency, and overcame its initial inhibitions about moral hazard and individualized debt responsibility. The ECB also evolved, departing from its early Bundesbank-type inflation phobias. The only serious step that remains to be accomplished is the cleanup of its banks’ balance sheets. To this end, the ECB’s proposed quantitative easing will provide some help, by pushing down yields and boosting bonds prices. One more reason to do it, quickly.
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