• By
  • Paul Hannon

The European Central Bank hopes its trillion-euro plan to buy bonds, using freshly created money, will help revive the eurozone’s stagnant economy and push inflation back toward its target rate of just under 2%.

How will the policy adopted by the ECB—generally known as quantitative easing–accomplish those goals?  Here are several ways:

1. One immediate boost to output could come through pushing the euro lower against other major currencies, or at least ensuring its depreciation since May isn’t reversed. That could help exporters and increase output, while it could also help raise inflation by making imported goods and services more expensive in euro terms.

2. There is also what’s known as the portfolio rebalancing effect, which would take a longer time to play out. That relies on the sellers of government bonds to the ECB using the cash they receive to buy other assets or make loans that help increase spending and investment. Most sellers of the bonds will likely be banks, and ECB President Mario Draghi said they will have a fresh incentive to lend to businesses and households. The problem is that with confidence in both camps still weak, businesses and households may not want to borrow.

3. Mr. Draghi also spoke about the “signaling effect.” By taking the difficult and long-resisted step to pursue QE, the ECB hopes it has convinced households and businesses that it really is determined to push inflation back to its target soon. The open-ended nature of the program underlined that message. While the ECB intends to complete its bond purchases by September 2016, Mr. Draghi said it would “in any case” continue until there were clear signs inflation is on the rise.

There are two ways this message can work if it gets through and is believed. First of all, a rise in expected inflation lowers real interest rates. The ECB’s main interest rate is close to zero, so if you expect prices to fall over coming years, the real interest rate is positive. If you expect the inflation rate to be 2%, the real rate is minus 2%.

The other way it might work is by persuading businesses and households that their profits and wages will rise in coming months. If you think falling prices will cut your cash profits, it’s a bigger risk to borrow and invest. As a household, if there is reason to fear wages will fall, it’s a bigger risk to make a major purchase that has to be paid for over a number of years.

The big intangible is confidence. The eurozone has been enduring a long slump without any convincing demonstration by policy makers that they’ve got the means to revive growth and are willing to take a gamble. The ECB may just have offered some hope to beleaguered businesses and households. And while Mr. Draghi stressed that governments have to do their part by pushing through painful economic reforms, that’s a start.

Related reading:

ECB Unveils Stimulus to Boost Economy

5 Things to Know About Eurozone QE

Who Owns the Government Bonds the ECB Will Buy?

Why Should Americans Care About European Central Bank Policy Moves?

Live Blog Recap: This Is Finally QE



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