The great distortion? Draghi's options on QE

Hopes of the European Central Bank (ECB) announcing a new asset-purchase program on Thursday have dwindled, although analysts remain critical of the current measures the bank has put in place.

A Reuters poll of economists this week showed that none of them expected any action to be unveiled at the end of the ECB's Governing Council meeting. The Council's rate decision is due at 12:45 p.m. London time, with ECB President Mario Draghi speaking in front of the press shortly afterwards.

"Expectations are diminishing for anything spectacular at the this week's meeting – except kicking that can down the road," Bill Blain, chief fixed income strategist at brokerage firm Mint Partners, wrote in a research note on Tuesday.

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'Limited progress'

European Central Bank President Mario Draghi attends a tribute to the late economist and lawmaker Luigi Spaventa in Milan, Sept. 27, 2013.
Pier Marco Tacca | Getty Images
European Central Bank President Mario Draghi attends a tribute to the late economist and lawmaker Luigi Spaventa in Milan, Sept. 27, 2013.

After fragile signs of a recovery last year, the euro zone bloc has suffered from subdued inflation in 2014, with the specter of deflation looming, and gross domestic product (GDP) figures that have seen Italy fall back into recession and Germany post negative growth.

Draghi has launched a slew of easing measures this summer to try to boost inflation back up to desired levels. As well as cutting interest rates, he has committed to purchasing bundled loans called asset-backed securities (ABS) and covered bonds, to expand the ECB's balance sheet and stimulate the moribund economy. Central bank watchers remain unconvinced that this has had the desired effect.

The bank has revealed it bought 368 million euros ($459.41 million) worth of ABS over the week ending November 28 - the first week of the most recent operation. It has also managed to buy 17.8 billion euros of covered bonds. Chris Scicluna, head of economic research at Daiwa Capital Markets, called the uptake "minuscule" in a research note on Tuesday, and Barclays analysts said it was "limited progress." Blain criticized it as "blisteringly insignificant." The demand for its ultra-cheap loans, dubbed Targeted Long Term Refinancing Operations (TLTROs), is also failing to inspire confidence.

The great distortion?

In light of this weak start, many economists are now expecting the ECB to start buying corporate bonds or even sovereign debt of euro zone nations. A Reuters poll of these market watchers predicts that this could be announced as early as March 2015. Draghi will emphasize his ongoing preparations for this more substantial policy easing on Thursday, according to Barclays, who believe that he'll maintain his dovish tone at his regular press conference.

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The corporate debt measures would mean buying unsecured, short-term debt instruments issued by a corporation. But Blain believes that this would be the ultimate example of the "great distortion", whereby the ECB buys at the very top of the bull run in the bond markets, rewarding every investor who has held on to their bonds.

If it opts for sovereign bond purchases, then it would face tough opposition from Germany. The country is the largest euro zone economy, and would likely be the recipient of the largest amount of ECB cash under a full-scale QE (quantitative easing) program. There are fears on the part of German policymakers that it could stoke inflation, and give struggling euro zone governments an excuse for not implementing the fiscal reforms they need.

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Another option

An alternative suggestion for the ECB comes from Luis Garicano and Lucrezia Reichlin, two professors from the Centre for Economic Policy Research. Their proposal, uploaded to the research center's website last month, suggests that the ECB buy "safe market bonds". They explain that these would be synthetic bonds formed by the best rated sovereign bonds combined in GDP-weighted proportions.

Regardless, expanding its balance sheet could be a very long and difficult task, according to Azad Zangana, senior European economist at Schroders. Demand from the banks will see a modest improvement next year, he said, but is likely to take longer than many expect.

"The lags on monetary stimulus can be long, and with a system that is still sickly, attempting to grow its loan book when demand is subdued will be difficult," he wrote in a research note on Tuesday.