Economic News & Analysis—September 6, 2012

European Central Bank bond-buying program

By Brian Jacobsen, Ph.D., CFA, CFP®, Chief Portfolio Strategist

After its meeting earlier today, the ECB announced it would leave its benchmark rate unchanged because it sees moderate inflationary pressures coming down the pipeline from higher commodity prices. The more significant outcome of the ECB’s meeting is that the members of the ECB agreed to the architecture of a bond-buying program to support the eurozone. This policy move is one reason why we have decided to pivot toward Europe when looking for investment opportunities.

The bond-buying program of the ECB is designed to lower the cost of short-term borrowing for sovereigns that seek bailout funds from the European Financial Stability Facility, the European Stability Mechanism, or another international lender (like the International Monetary Fund). The ECB’s support of the short-term debt market includes the governments not only asking and receiving a bailout but also abiding by the conditions of the bailout. Politicians in Spain have been resistant to asking for a bailout, so the ECB program might not help the Spanish bond market until the politicians humble themselves and go cap-in-hand for a bailout.

To help make the ECB’s bond-buying program more politically palatable, the intervention will be fully sterilized. When the ECB buys a security (or any asset), it increases the quantity of bank reserves in the financial system. That could lead to an expansion of the money supply if those banks lend their reserves to customers, which could then be inflationary. To offset the increase in reserves—that is, to “sterilize” the asset purchase—the ECB can either sell a different asset or entice banks to just hold the reserves at the ECB instead of lending them out. Considering there is a credit contraction going on in the eurozone, that might seem strange, but that’s the nature of the politics of central banking: To get more buy-in for the program, the ECB wants to show that it is not “monetizing” the debt of governments. The ECB action is designed to lower the debt-servicing costs of governments asking for help. It is not designed to expand the money supply.

Politicians seem to be embracing the idea that the hard austerity being imposed or practiced throughout the eurozone is counterproductive. Hard austerity is an abrupt increase in tax collections to close budget deficits. Instead, they seem to be advocating soft austerity, which draws out the timeline over which budget deficits are closed and to change the way budget deficits are trimmed or eliminated. Instead of increasing tax collections dramatically, they are beginning to promote growth through regulatory reforms and pursue programs that trim the size of government budgets. Encouraging labor mobility and job creation is one way to dig out of the hole they’ve dug.

Monetary, fiscal, and regulatory policies can push in the same direction or opposing directions. Although fiscal policy is still restrictive in Europe, it’s not as restrictive as it once was. This could bode well for the eurozone markets in the short term as monetary policy is now more expansionary.

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