Eurozone bank adds sovereign debt purchases to stimulus plan.
The eurozone has recently been suffering from a period of low inflation. The condition threatens economic growth across the nineteen countries that use the euro as their shared currency. To combat this problem, the European Central Bank (ECB) recently decided to supplement its monetary policy by broadly expanding an asset-buying program it began late last year called quantitative easing.
The ECB’s decision is controversial, but may be essential to saving the eurozone from dire economic circumstances. Some analysts see the move as the ECB’s “last remaining major policy option for reviving economic growth and warding off deflation.” The move characterizes ECB President Mario Draghi’s stated commitment to do “whatever it takes” to save the euro.
Quantitative easing occurs when a central bank purchases assets out of its economy. These assets are usually securities that financial institutions own and hold. Central banks perform quantitative easing as a supplement to regular monetary policy, primarily to increase the value of the assets that remain for sale in the markets and inject more liquid capital into the economy.
After lowering interest rates and buying privately held assets (two traditional forms of monetary policy), the ECB announced last month that it would expand its quantitative easing program by purchasing sovereign debt as well. Sovereign debt refers to bonds a country issues in order to support its growth.
Several European countries that do not like the program have expressed opposition to it. The controlling legal framework – the Statute of the European System of Central Banks and of the ECB – prohibits the ECB from directly financing governments. The statutes permit the ECB to purchase government bonds only if it does so from a secondary market and not directly from the member states. Already, the head of Germany’s central bank has voiced criticism against expanding the supply of money in the eurozone.
The ECB, however, has highlighted the potential benefits of structuring the purchase program to operate across the eurozone, claiming that it broadens the scope of the interventions and amplifies their monetary impact. The ECB has argued the cross-border market is deep and liquid enough to minimize any potential distorting effects of a centralized program. Furthermore, the ECB has contended that by buying the debt from a secondary market – after the price has already formed – the ECB does not risk influencing the market price of the bonds.
The ECB’s primary objective is price stability in the euro area, which can strengthen investor confidence by supporting inflation expectations. Central banks perform quantitative easing in order to achieve a level of equilibrium in the economy between excessive cash supplies in the economy (which can lead to hyperinflation) and low inflation growth, which leads to tightened lending conditions and higher unemployment. Quantitative easing can support price stability by bringing inflation up to healthy levels, making access to financing easier for borrowers (including households and small businesses), and freeing up institutions that sell assets to issue debt and buy other real assets.
The current period of low inflation throughout Europe is due to a number of factors, including the recent unexpected drop in oil prices. The ECB plans to counter the lack of growth by “expand[ing] the size and change the composition of the Eurosystem’s balance sheet” in order to hit its inflation target of just below 2%.
In its press release in January, the ECB issued answers to potential questions, such as inquiries into the legality and risks of the purchase program. The ECB faces criticism over the program because it operates across nineteen countries in the eurozone who do not all share the same standards or attitudes toward sovereign debt purchases.
Some analysts have speculated that the ECB Council factored investor expectations of ECB behavior into the decision to expand the program. Many analysts and investors expected the ECB to make the announcement it made in January; indeed one of the members of the ECB executive board stated that a failure to make the announcement would have rippled throughout European markets, due to the investor expectations that an announcement was imminent.
The increasingly cross-border nature of banking presents both opportunities and challenges to central banks, which must also consider the demands that sophisticated, observant investors place on them. One analyst described the ECB as a “prisoner of the expectations it had created” among investors last December when it announced the original asset-purchase program.
Although sovereign debt purchases are a standard method of supplementing monetary policy, the latest announcement marks the first time the ECB will make such purchases. The ECB will purchase €60 billion per month in combined public and private sector assets, made in proportion to each member country’s size, until at least September 2016.