ECB's options narrow in bid to rescue euro zone economy

Quantitative easing is one of the options that could stabilise European banking

IS PRINTING money the next step for the European Central Bank (ECB)?

Quantitative easing, the hot topic among central banks for months now, yesterday became a reality at the Bank of England, which announced that it would pump £75 billion (€84 billion) into the British economy by buying government bonds (gilts) and corporate assets over the next three months.

It is a move often described as “printing money”, although its machinations are rather more sophisticated than gearing up the printing presses and handing out the cash.

Unlike liquidity injections, which merely change the pattern of flow of existing money around the financial system, quantitative easing involves flooding additional money into a cash-starved system.

The banks get more money, which in theory they will then use to lend to small businesses and consumers, jumpstarting the economy.

The Bank of England has embarked on this course because it is running out of scope on interest rates faster than the ECB. Having cut its key rate to a record low of 0.5 per cent yesterday, it appears reluctant to go all the way to zero in a bid to keep the British economy afloat. The alternative is the “non-conventional” printing money path.

So, with credit markets still frozen, is the ECB next in line?

ECB governing council president Jean-Claude Trichet has repeatedly expressed reluctance to go down this path and recently stressed the dangers of quantitative easing, which primarily involve creating a bubble in bond values that ultimately results in sharp increases in interest rates.

Significantly, governing council member and German Bundesbank head Alex Weber told German television that printing money should only be an option if there was a “marked deflation risk”.

But the dire inhouse economic forecasts published by the ECB yesterday suggest that a kitchen-sink approach to rescuing the euro-zone economy may yet be employed. Forecasting a deep and bloody recession, the ECB said that inflation, as measured by the harmonised index of consumer prices (HICP), would be in the 0.1-0.7 per cent range this year, while next year it would not exceed 1.4 per cent.

While this is still inflation rather than deflation, it is far below the ECB’s target inflation mantra of “below but close to 2 per cent” and also far short of the 1 per cent inflation rate at which interest rate movements are said to become less effective.

The fear is that prices have already become unstable and will plummet into an extended debt-deflationary spiral, with a sustained fall in prices increasing the real value of debt.

Most economists agree, for the moment at least, that the ECB’s key lending rate, cut from 2 per cent to a historic low of 1.5 per cent yesterday, will find its floor at 1 per cent: for Weber, at least, this is “the lowest limit”.

Meanwhile, one “non-conventional” measure implemented by the ECB in the wake of the Lehman crisis is fast becoming normal practice: rather than holding competitive auctions for liquidity, the ECB is providing banks with as much debt as they want in its refinancing operations.

Yesterday, Trichet said the ECB would extend this practice into 2010 and thereafter as long as banks need it.

It’s a kind of credit morphine that’s quietly drip-dripping into the euro-zone banking system. It remains to be seen whether quantitative easing becomes the next addiction.