Europe News

Draghi’s Toolbox: Bond-buying bazooka on the way?

It's a big week for the European Central Bank (ECB), with President Mario Draghi widely expected to unveil stimulus measures to give the euro zone's sluggish economy a boost and halt a growth-sapping fall in prices on Thursday.

Over the next three days, we'll take a look at the tools at Draghi's "toolbox". First up is perhaps the most "unconventional" of policy instruments: a bond-buying, or quantitative easing (QE), program.

What is it?

Under QE, a central bank buys up assets – usually government bonds - in an effort to boost money supply. The hope is that the financial institutions which sell these products will respond to the capital boost from the central bank by increasing lending across the economy.

ECB action not fully priced in: Pro

Another result of QE is increased demand for sovereign debt, which pushes its price up – and yields down – thereby making it cheaper for governments to borrow.

Why do it?

Lending is a sign of a buoyant economy. However, loans to small and medium sized businesses – the backbone of the euro zone economy -- continued to fall in April.

Read MoreThe chart that's pushing Draghi to act

The most recent gross domestic product (GDP) figures for the region put paid to any notion of a sustained recovery, with the economy expanding by just 0.2 percent in the first quarter.

There are also concerns about low inflation, with euro zone consumer prices coming in below expectations in April, rising by 0.7 percent year-on-year, although this did mark an uptick from March's 52-month low of 0.5 percent.

If the central bank targeted sovereign debt – like the Federal Reserve in the U.S. – banks' balance sheets would get a boost. This should bolster lending to both businesses and individuals, encourage spending and help alleviate the risk of deflation. It should also push government bond yields lower, helping states to borrow and stimulate their economies.

Why not?

The ECB has not yet launched a QE program, mainly because there are no common euro zone bonds and the process of picking which country's debt to buy is fraught with political dangers.

Read MoreECB to get drastic? QE could be on the table

If the ECB purchases the sovereign assets of one euro zone country, for example, it implies the same risk for the whole of the euro zone, ignoring the high credit risk of some peripheral nations and the low credit risks of countries like Germany.

Also, any "monetary financing" of governments by the ECB is also banned by European Union - another key stumbling block for the central bank launching a QE program of this sort.

What about the private sector?

Another option open to the ECB is allowing banks to parcel together loans on their books into saleable instruments called asset-backed securities (ABS). The ECB could then buy these ABS, freeing up capital for the banks.

However, ABS have a somewhat tarnished reputation -- wild trading in these instruments helped spark the 2008 financial crisis. Plus euro zone countries have different amounts of asset-backed securities, and there are difficulties in assessing their risk and price.

What the experts think

BNP Paribas economists, led by Ken Wattret, have argued for some time that "ECB QE is coming", as other measures cannot deliver sufficient clout.

The economists forecast the ECB will announce an initial program in the range of 300-500 billion euros ($415-$690 billion) – although they stressed that predicting the size of the program is "more of an art than a science."

Acknowledging the difficulties in a private sector program, however, the BNP Paribas economists added: "We conclude that some such (private sector asset) purchases are likely (and will be beneficial) but that, like other central banks, the ECB will also have to use the sovereign debt markets to find the depth and liquidity required for purchase programs of meaningful size and impact."

Read MoreQE from ECB? May not be the panacea many hope

Goldman Sachs analysts led by Huw Pill, however, said the likelihood of a Fed-style large-scale asset purchase program remained small, as the purchase of sovereign assets would "raise questions about the ECB's legitimacy in introducing a fiscal union through the back door".

He also queried the effectiveness of a QE program on yields, given that sovereign yields are already very low, even in peripheral countries.

"This is consistent with the experience of the Bank of England's QE programs, which suggests that the effectiveness of purchases falls once yields are very low," he wrote in a note.

Carsten Brzeski, senior economist at ING, said he expected a "big QE bazooka" to remain in the closet, for now at least.

"The ECB is caught between the high expectations it created and concerns about unprecedented measures such as QE being too risky and controversial to really test them," he wrote in a note.

—By CNBC's Katrina Bishop