The link between US monetary policy and US bond yields has fallen apart this year, showing how fears of deflation in Europe are driving global financial markets.
Deflation knocks at ECB`s door, markets look for cash boost
Speculation is rising that the ECB`s decision-making governing council could signal plans for what is known as "quantitative easing" or "QE" at its regular monthly meeting on Thursday.
This is a radical policy -- already used by other central banks such as the US Federal Reserve -- of buying securities on a big scale to inject cash into the economy.
The ECB has already cut its key interest rates to record lows and made huge volumes of ultra-cheap cash available to banks in a bid to kick-start lending in the singe currency area.
But the pressure has increased on the ECB to take still more measures after eurozone inflation slowed to a paltry 0.3 percent in August from 0.4 percent the previous month.
That is worryingly below the central bank`s target of just under 2.0 percent and brings the single currency area perilously close to deflation, a climate of falling prices which can cause businesses and consumers to delay purchases, further reducing demand and prices and pushing up unemployment.
Analysts said they were convinced that the ECB is now planning QE after its president Mario Draghi said recently that the bank is becoming concerned about falling inflation expectations.
The ECB as "ready to adjust (its) policy stance further" and "will use all available instruments needed to ensure price stability over the medium term", Draghi said.
The remarks sparked a rally on European financial markets early last week."The ECB finally seems to be facing facts, with Draghi conceding... that the economy is too weak and that inflation expectations have dropped," said Capital Economics economist Jennifer McKeown.
The central bank "has put a lot of emphasis on long-term financial market inflation expectations in recent months, stating that a decline would be the `context for` a broad asset purchase programme", McKeown said.
"So it seems that the final barrier to quantitative easing has been broken," she said.
Nevertheless, such a move was "still not imminent. The ECB is unlikely to announce QE this month or next," the expert said.
The central bank would first wait to see the impact of its new liquidity-providing programme or "Targeted Longer-Term Refinancing Operations" (TLTROs), the first of which would be held in mid-September, McKeown said.
The sluggishness of the economic recovery is another argument in favour of action.
ECB governing council member and Austrian central bank chief Ewald Nowotny said that he was "worried" about the outlook for eurozone growth, and that eurozone recovery was slower than the ECB had expected.
"Draghi`s warnings against the decline of long-term inflation expectations seem to be motivated by concerns about economic growth," said Commerzbank economists Joerg Kraemer and Michael Schubert.
Hence, they put the possibility of the ECB launching QE in the coming months at 60 percent, the analysts said.
"The ECB`s optimistic medium-term economic outlook is crumbling. But unless a notable recovery occurs, inflation will not move towards the ECB`s target of 2.0 percent," they said.Deutsche Bank economists Mark Wall and Gilles Moec suggested that the ECB might even embark on private QE -- in the form of asset-backed securities (ABS) -- as early as this week. Such a policy would greatly widen the range of paper assets which the central bank would buy from the balance sheets of financial companies, replacing them with ready cash.
"What we expect is not generic QE with government bond purchases, as other central banks have done," they said.
"We believe the ECB will engage in private QE, that is ABS purchasing as a complement to the TLTRO" or liquidity programme.
ECB chief Draghi has repeatedly said preparations for such an ABS programme are underway.
McKeown at Capital Economics said the effects of QE were still uncertain.
"But the growing risk of deflation in the eurozone suggests that it has to be worth a try," she concluded.
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