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Central Bankers Eye 'Drug' That Is Bond Buying

Investors across the world are awaiting further news on whether the European Central Bank (ECB) and the Federal Reserve will decide to turn the quantitative easing (QE) taps on and begin buying bonds aggressively in a bid to kick-start ailing growth in Europe and the United States.

Opposition to pumping more money into the system is being led by the Bundesbank and its boss Jens Weidmann who likened bond buying by central banks to a “drug” that governments would get hooked to.

"Such a policy is for me close to state financing via the printing press," Weidmannn told German magazine Der Spiegel on Sunday. "In democracies, it is parliaments and not central banks that should decide on such a comprehensive pooling of risks," said the central banker.

“We should not underestimate the risk that central bank financing can become addictive like a drug," said Weidmannn who indicates he is not alone in his opposition to more QE (CNBC Explains: How Does Quantitative Easing Work?). "I hardly believe that I am the only one to get stomach ache over this.”

The big question is who supports Weidmannn’s view and who is supporting turning on the printing presses ahead of the ECB’s meeting on September 6th? The governments of Spain and Italy have made it clear they want more help from the ECB (More here: Spain Seeks Forceful Bond Buying by ECB) and the French government of Francois Hollande appears to be backing his colleges on the periphery. Reading Angela Merkel’s intentionsare more difficult.

Following Weidmannn’s comments on Sunday the Chancellor voiced support for the Bundesbank head without throwing her weight behind his call on buying bonds. "I think it is good that Jens Weidmannn warns the politicians again and again," Merkel said in an interview with public broadcaster ARD. "I support Jens Weidmannn, and believe it is a good thing that he, as the head of the German Bundesbank, has much influence in the ECB."

Supporting the man and not the idea allows the Chancellor to walk a thin line between shoring up domestic support, given the majority of German voters are opposed to measures which risk driving up inflationor handing German tax euros to other euro zone members and taking a lead role in the debt crisis.

Merkel needs to avert contagion in the euro zone debt crisis and knows the only way to stop borrowing costs in Spain and Italy jumping in the short term is via the European Central Bank (CNBC Explains: How Does the ECB Work?).

Reports indicate the ECB governing council continues to debate whether or not to set a target on euro zone government debt yields while attempting to stop speculators cashing in on such a move. Late on Friday the Reuters news agency reported that the setting of a yield band is gaining favor among the council.

"That is the most likely approach, and also the one that could be most successful,” said an unnamed source at the ECB.

We may have to wait for nearly two weeks before we get the answer on what the ECB will do, but on Friday in Jackson Hole, a keynote speech by Ben Bernanke could offer further clues on how the Federal Reserve (CNBC Explains: What Is the Federal Reserve?) will respond to the slowdown in the U.S. economy.

With expectations building that the U.S. central bank is set to ease policy further following last week’s release of minutes from the Fed’s July 31st and August 1st meeting, one policy maker indicated in an interview with CNBC he expected more intervention.

There’s "a lot of reason to do more,” said Chicago Fed President Charles Evans in an interview with CNBC in Asia on Friday.

James Bullard of the St. Louis Fed did not share Evans’ view telling CNBC on Thursday last week that growth of around 2 percent would keep the Fed on hold.

“Probably the best thing to talk about here is what would that action really be," he said. “I think the markets have the idea of some gigantic action. I'm not sure if the data really warrants that.”

Fed watchers believe the central bank will do something but are unsure when any intervention will be announced. For more, read: The Heat Is on Bernanke—but Will He Say Anything?

“Having whipped up market excitement to fever pitch with the August 1 FOMC minutes, revealing that “many members” think additional monetary action “will likely be warranted fairly soon”, the Fed is now almost at the point where the failure to implement further asset purchases would entail a significant loss of credibility,” said Ian Shepherdson, the chief economist at Pantheon Economic Advisors in a research note on Sunday.

It would take a payroll gain of 200k plus or an ISM manufacturing index of 55 to stop the Fed acting, according to Shepherdson, who sees little chance of such a rebound in the data.

“The next question is what the Fed hopes to achieve, and here we are at something of a loss. The key point of QE is to reduce long-term interest rates, thereby reducing the cost of credit for borrowers and the risk-free returns for investors, pushing them into risky assets instead.”

“Our core problem with the idea of QE3 is that the cost of credit is no longer a significant problem; availability is the issue, but it is steadily improving,” said Shepherdson.

Others think the recent improvement in U.S. data have lessened pressure on the Fed to announce further easing but still believe QE3 is on the way. “At a minimum we expect officials to extend their forward guidance on rates at the September 12-13 meeting, with a slightly-better-than-50% chance that a new asset purchase will be announced then as well,” said Jim O’Sullivan, the chief US Economist at High Frequency Economics, in a research note.

As Republicans gatherin a windswept Tampa for their national convention, O’Sullivan said he did not expect the election cycle to impact the Fed’s decision making. “Still the proximity of the October 23-24 FOMC meeting to the November 6th election could, on the margin, encourage officials to act in September or wait until the December 11-12 meeting.”