After many months of speculation, the European Central Bank [ECB] has finally announced that it is to embark on a policy of Quantitative Easing [QE]. The programme will begin in March 2015 and the ECB will purchase €60 billion per month until September 2016 or until inflation returns close to its 2% pa target.
The reason the ECB embarked on this venture is because policy makers are concerned about the falling rate of inflation and the sluggish pace of economic activity in the Euro zone which they fear will tip the Eurozone into deflation.
The theory is that QE wards off deflation and boosts investment and spending by encouraging banks to lend more money. QE is often described as ‘printing money’, which increases the amount of cash in circulation and consequently reduces the value of the euro in your pocket. In modern times, the ECB will simply create new money electronically which it will then use to buy assets, such as government bonds as well as bonds from the private sector.
The new money boosts the size of bank reserves in the economy and the extra demand for government bonds should do two things:
1. Drive up the price and push down the yield on those bonds, making them less appealing to investors, who instead put their money to work in riskier assets.
2. Push down the borrowing rates for consumers and businesses and encourage them to stop saving and start borrowing and spending.
This type of radical stimulus has been tried in the US, the UK and more recently, in Japan. Fierce debate continues about its effect and success.The ECB programme has many critics who say that it leads to an increase in asset prices which benefits mainly the rich and the rich tend not to spend their incomes and instead save their money in safe havens.
We will know if QE works if, over time it reduces the value of the euro which will boost exports and crucially, lift inflation, as imports cost more.