Massive monetary intervention looms on both sides of the Atlantic

On Thursday, the European Central Bank (ECB) announced a far-reaching measure to finally tackle head-on the long-simmering debt crisis in the Eurozone.

The ECB will purchase unlimited quantities of sovereign bonds in a bid to lower interest rates for troubled Eurozone countries such as Spain and Italy. The program will also help to alleviate fears of investors that the Euro might ultimately convert to other currencies resulting in unforeseen losses.

In the backdrop of muted inflation ranging around 2%, weak economic growth in the European area and low business confidence because of tensions in the financial markets, the ECB will conduct “Outright Monetary Transactions” (OMTs) in the secondary markets for sovereign bonds having maturities ranging from one to three years in the euro area.

Reproduced below are some of the remarks by ECB President Mario Draghi at the press conference in Frankfurt:

“A renewed intensification of financial market tensions would have the potential to affect the balance of risks for both growth and inflation…We need to be in the position to safeguard the monetary policy transmission mechanism in all countries of the Euro area…We aim to preserve the singleness of our monetary policy and to ensure the proper transmission of policy stance to the real economy throughout the area.

OMTs will enable us to address severe distortions in government bond markets which originate from, in particular, unfounded fears on the part of investors of the reversibility of the euro.

We will have a fully effective backstop to avoid destructive scenarios with potentially severe challenges for price stability in the euro area…The euro is irreversible.”

The ECB’s support action must be matched by the supported countries that are required to embark on a program to control their fiscal imbalances and their governments must agree with the ECB on discipline in this regard. According to Draghi, this conditionality provision is a vast improvement on similar previous measures, and therefore most likely to be successful this time around.

The effect of the ECB’s plan was to lower immediately the borrowing costs of troubled countries such as Spain and Italy. In the long run the ECB’s bond purchase program is a stop gap measure that would allow indebted countries in the region to avail of borrowings at lower costs while they restructured their struggling economies.

Unfortunately, this program may also result in inflationary pressures, this being a grouse of Germany in particular. Germany has been critical of such interventions in financial markets as they result in the creation of fiat money using printing presses. The country also fears that the expansion in money supply stokes inflation.

The ECB plans to address German fears of inflation by “sterilising” the funds used in the bond purchase program. This effectively involves sucking out the same quantity of money by offering interest-bearing deposits to banks.

In a significant insight into the ECB action, EconomyPolicyJournal.com point out that by doing away with credit rating norms for paper issued by countries approved for ECB assistance, the ECB has made it possible for these countries to access virtually an unlimited amount of funds by issuing sovereign guaranteed paper that can be used as collateral by their banks for drawing assistance from the ECB.

There appears to be no thought to the risk carried by the ECB in case any of these countries were to default.

Markets around the world however greeted the ECB action by pushing up stocks and the value of the euro.

Across the pond, the US Fed expressed its concerns at the slow pace of economic recovery and stubbornly high levels of unemployment, hinting at a possibility of yet another round of quantitative easing. According to the minutes of the meeting held on July 31, “participants expected that such a program could provide additional support for the economic recovery both by putting downward pressure on longer-term interest rates and by contributing to easier financial conditions more broadly.

On August 31, Fed President Ben Bernanke, speaking at Jackson Hole, expressed fears regarding the stagnation of the labour market and said “persistently high levels of unemployment will wreak structural damage on our economy that could last for many years.”

His apprehensions seemed to echo in the latest employment data out of the U.S. – Non-farm payrolls for August increased by a weak 96,000 jobs instead of the expected 125,000. Worse, the data came on top of downward revisions to figures for June and July. Though the unemployment rate fell to 8.1% from 8.3%, this was due to shrinkage in the workforce rather than more jobs.

The figures lend weight to the expectation that another round of quantitative easing, dubbed “QE3” may be round the corner. Though the jury is out on the size of the program, it may be larger than QE2, which was $600 billion in purchases of treasury paper. The assets of choice are likely to be treasury notes or mortgage-backed securities, or a mix of the two.

The recent QE noises by the Fed resulted in a sharp fall in the value of the dollar (due to fears that the action would result in a “debasement” of the currency) and a rise in the price of bullion such as gold and silver.

It may be useful to know the difference between the actions of the ECB and the Fed. The Fed usually acts to release money to mop up assets resulting in a net increase in the money supply. The ECB will, however, drain excess money through a sterilization process.

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