Is ECB taking its first steps to effectively print money?

ANALYSIS:Trichet has announced the purchase of up to €60 billion worth of covered bank bonds, writes LAURA SLATTERY

LIKE A laxative pill designed to unclog euro zone credit markets that have been clenched tight since the fall of Lehmans, quantitative easing has been prescribed by European Central Bank (ECB) president Jean-Claude Trichet and his fellow governing council members – well, kind of.

Quantitative easing has already been dispensed by the ECB’s US and British counterparts but, as medicines go, it is still highly experimental – and not without the risk of serious side-effects.

This is a move sometimes described as “printing money”, although its machinations are somewhat more complicated than cranking up the printing presses, breathing in the scent of fresh notes and doling out the cash.

Under quantitative easing, central banks expand their balance sheets by buying government bonds (gilts) and/or corporate assets – which pumps extra money into the economy.

Yesterday, after months of internal bickering, the ECB said it would buy up to €60 billion in covered bank bonds – or securities issued by banks and backed by mortgages or other loans.

By stopping short of the massive asset purchase programmes being pursued by the US Federal Reserve and the Bank of England, the ECB is adopting what it called a preliminary “credit easing” approach.

“Printing money” was not something that Trichet was ready to confess to at yesterday’s ECB press conference in Frankfurt.

For the Irish economy, open to the point of intense vulnerability, anything the ECB eventually does to revive euro zone economic activity – now stabilising “at very low levels”, according to Trichet – is hugely significant. But the effect of the ECB’s policy on exchange rates is nearly more crucial. Irish exporters need a weaker euro.

The reaction on the currency markets told its own story. The euro climbed to a one-month high against the dollar as traders reckoned the €60 billion plan wasn’t aggressive enough to debase the currency. Meanwhile, the announcement by the Bank of England of a comparatively larger money-printing exercise pushed sterling weaker against the euro.

Although Trichet noted the ECB had taken measures that are “unprecedented in nature, scope and timing” since the intensification of the financial crisis in September 2008, many critics believe its ultra-cautious stance is self-defeating.

Most of the €1.5 trillion euro zone market for covered bank bonds is located in Germany, where they are called pfandbriefe and considered among the safest corporate bonds available. This should come as no surprise. Playing safe is more or less the ECB’s official position.

The size of the ECB credit-easing announcement is modest compared to the £75 billion (€84 billion) of newly created money announced in March by the Bank of England.

Yesterday, its monetary policy committee unexpectedly lashed a further £50 billion into the mix and took its quantitative easing programme to a cool £125 billion (€140 billion). The first tranche of gilt purchases had failed to turn the UK economy around.

And that is one of the problems with quantitative easing. If the numbers are too small, it won’t make any difference. But if they’re too high, there is a risk that the sudden flood of money circulating around the financial system will eventually cause the kind of dramatic spike in inflation that prompts central banks to increase rates, not decrease them.

Having lapped up a series of rate cuts, the last thing Irish households need is a reversal of those rate cuts.

But those are fears for a later day. For the moment, deflation rather than inflation remains the big threat. Yesterday, Trichet indicated for the first time that 1 per cent was not necessarily the floor for its key lending rate: after cutting rates by a quarter point yesterday, further interest rate cuts could still be on the cards.

This is good news for the Irish economy, as even at the historic low of 1 per cent, the euro zone base rate is too high for Ireland, where deflation is pushing up the real value of Government debt.

In Ireland, the Harmonised Index of Consumer Prices (HICP) became deflationary in March, with prices declining at an annual rate of 0.7 per cent. In the euro zone, the flash HICP estimate for April was a positive rate of 0.6 per cent – not quite deflation, but heading there.

ECB experts believe that once inflation sinks below 1 per cent, interest rate movements become less effective as a monetary policy tool: in other words, cutting rates becomes next to useless in getting the economy flowing again. That’s why some commentators believe it is only a matter of time before Trichet converts from “credit easing” to the gilt-buying, printing money kind. The ECB hasn’t pulled out all the stops just yet.