Quantitative easing, deflation explained

The European Central Bank is expected to launch a programme of sovereign bond purchases, known as quantitative easing or QE, at its policy meeting Thursday to ward off deflation in the eurozone.
But QE, already used by other central banks around the world to stimulate their economies, is controversial in Europe because it is seen as a way of printing money to pay the way for governments out of debt, which the ECB is expressly forbidden from doing under its statutes.
And while consumer prices in the single currency area actually fell for the first time in five years in December, analysts and ECB officials insist that there is no sign of deflation in the region just yet.
- What is deflation?
Deflation is defined as an extended period of falling prices where consumers begin to put off purchases in expectation they will fall further, sparking a damaging cycle of falling production, employment and prices.
Consumer prices in the eurozone fell by 0.2 percent year-on-year in December, the first drop in more than five years, driven down mainly by tumbling oil prices.
But a one-off like that is not synonymous with deflation, economists said.
"So maybe that Sunday car trip gets postponed because petrol could be cheaper next week ... Really? Of course not. For all the other stuff, prices are still going up, and that's the key input in what households expect for future inflation," said UniCredit chief economist Erik Nielsen.
In fact, he suggested that a "negative price shock, which raises real income is good news. This is good for Europe."
His colleague at Berenberg Bank, Holger Schmieding, agreed, noting that consumer confidence remains high, which would not be the case in a deflationary scenario.
ECB officials, too, have repeatedly stated that they see no sign of the eurozone sliding into deflation for now, even if the central bank's chief economist Peter Praet insisted that the ECB "could not afford the luxury" of sitting back and doing nothing.
Normally, central banks keep inflation (and deflation) in check by adjusting their key interest rates.
If the economy is in downturn and companies are nervous about the future and scaling back on investment, a central bank can reduce the overnight rate that it charges banks, reducing their funding costs and encouraging them to make more loans.
In the wake of the financial crisis, the ECB, like other central banks around the world, slashed their overnight interest-rates to close to zero. But that still failed to spark a sustained recovery, so they resorted to more unconventional tools to encourage banks to pump money into the economy, including QE.
- Does QE work?
Under QE, a central bank in effect creates money by buying securities such as government bonds from banks with electronic cash that did not exist before.
The aim is to stimulate the economy by encouraging banks to issue more loans: the banks take the new money and then buy assets to replace the ones they have sold to the central bank. That raises stock prices and lowers interest rates, which in turn boosts investment.
Economists said the QE programmes in the United States and Britain had worked.
Berenberg Bank economist Rob Wood estimated that Britain and the US averaged 3.0-percent nominal growth since embarking on QE, while the eurozone had only managed to clock up growth of 1.1 percent.
Central bank bond-buying "can aid confidence, depress yields and spreads, boost asset prices and lift growth," he said.