Next Thursday (January 22), the European Central Bank will be hosting an important meeting. Last year, Europe experienced a setback in their recovery from the debt crisis as growth ground to a halt. As a result, the ECB took a series of actions over the past several months in an attempt to support the recovery. Their efforts thus far have been considered lackluster by financial markets, which has led to growing speculation that ECB President Mario Draghi will resort to a large-scale asset purchase program (otherwise known as quantitative easing) in hopes of achieving the desired impact. Indeed, he has stated on more than one occasion that the ECB intends to restore the balance sheet back to its 2012 level, which translates into an expansion of nearly one trillion euros from its current size.
The question for markets has been how they will accomplish this; thus far, Draghi has tried to avoid purchasing government debt due to German concerns that it creates a moral hazard by relieving the pressure from other European nations that need to get their financial houses in order. However, with the latest inflation readings in Europe turning negative and growth remaining stagnant, Draghi is likely to act regardless. It has also become apparent that a large portion of any QE program will necessarily involve purchases of government bonds (due to size limitations of other types of securities they might consider).
Earlier today, investors learned that a major potential hurdle was overcome when the European Court of Justice delivered a preliminary opinion that appears to clear the legal way for QE. So, with market expectations for a new QE program solidified, next Thursday will be closely watched for the details of the program — its size and composition, specifically. We don’t pretend that quantitative easing will solve all of the economic challenges facing Europe – far from it, actually. European governments still have a big role to play in pursuing structural reforms that will boost long-term growth potential (which Draghi himself has been banging the drum for). But based on recent precedent in countries like the U.S. and Japan, if a QE program is large enough, it should have a significant market impact — particularly for risk assets that have been under pressure lately due to concerns about deflation, another political fiasco in Greece, etc.
As a result of all of this, eyes are once again on Draghi. Can he calm the market fears as he did in 2012? We will see.
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