European financial authorities have high hopes for quantitative easing across the Eurozone, but few know exactly how European Central Bank QE works.
ECB QE is a very different animal than similarly named methods in the United States and Japan. European Union treaties and German outcry over inflationary "money printing" measures have forced the ECB to pursue a program with a number of limitations.
When ECB president Mario Draghi announced ECB QE in a January 2015 ECB meeting it sounded rather simple.
ECB QE would be a 60 billion euro ($66.2 billion) a month bond-buying program. It would last from March 2015 to at least September 2016, aimed at bringing inflation up to a target rate of 2%. This would, over 19 months, add 1.1 trillion euros ($1.2 trillion) to the Eurozone financial system.
Those numbers are worth a closer look, but first, here's how QE works…
How ECB QE Works – Part 1: The Basics of QE
It's important to understand that ECB QE is not "money printing." And even just by itself, it's not inflationary.
Here's how it works. The European Central Bank – or one of the Eurozone member's national central banks – will transfer a government bond from a commercial bank's balance sheet to its own. The bond will show up on the asset side of the central bank's balance sheet. Then the central bank will credit the commercial bank's reserve account the value of that bond.
The central bank's balance sheet will increase on the asset side by the value of the bond, and the liabilities by the increase in value of the commercial bank's reserve account.
But in this transaction, the commercial bank's balance sheet doesn't change at all in value, only in composition. It is an asset swap. The commercial bank swaps a less liquid asset (a government bond) for a more liquid asset (euros).
All this does is increase liquidity within the commercial bank. It allows the banks a larger capacity to issue more loans.
As firms and households borrow that money and credit expands, more money is moving around in the economy. This is known as the velocity of money. It's this velocity that's supposed to help fight deflation and get dollars moving in the private economy.
In short, QE is an effort to facilitate a higher velocity of money by giving banks more lending capacity.