Recent years have seen several of the worlds most important central banks embark on new, largely untested “quantitative easing” (QE) policies.

These programs are designed to help keep long-term interest rates low, in order to stimulate economies at a time when official short-term interest rates have already been set to effectively zero for almost five years.

QE policies work through central banks purchasing bonds in the open market. In doing so, the price of bonds in the market is pushed higher and the yield (or interest rate) on these bonds comes down. This helps companies, consumers and banks borrow money at lower rates, encouraging investment, employment and confidence which drives up asset prices including shares and housing.

When the central bank purchases these bonds, they usually pay with newly created electronic funds from their own balance sheets. Thus, it is an increase in the money supply, and accordingly quantitative easing is often referred to as ‘printing money’ – since this is broadly equivalent to just printing more paper money to pay for the bonds.

Quantitative easing in the US has proved extremely positive for investors. The US share market has risen by 117% since the US Federal Reserve announced its first phase of the policy in November 2008.

With the US economy continuing to repair itself, the rate of bond-buying in the US is being reduced, to currently USD55bn a month, from USD85bn late last year. It will probably be reduced to zero by the end of the year.

The main risk resulting from QE is that it will lead to a surge in inflation – with prices in general increasing across the economy, and potentially destabilising bubbles in assets such as housing and shares.

For this reason, policymakers in Europe have long been reluctant to embark on a QE program of their own, despite little growth on the continent.

However, inflation is increasingly becoming something that European central bankers want, rather than fear. Figures released last week show annual inflation in the Euro zone of just 0.5% in the year to March, or 0.8% excluding volatile items (energy, food, alcohol and tobacco). This is down from 1.7% and 1.5%, respectively, a year ago.

So, inflation in Europe is running at a very low level, and despite official interest rates being set at zero there is a growing risk that prices in the Eurozone economy will begin to fall.  This is called deflation (general falling prices) and is very dangerous for an economy. It increases real interest rates, and damages investment, confidence and spending.

Against this backdrop it was not surprising to see the European Central Bank take a step closer towards beginning its own QE program last week, with ECB President Draghi commenting that ECB council members were now ‘unanimous’ in their support for such a policy, should it be deemed necessary over coming months.

So over the remainder of 2014, while the US Federal Reserve will likely stop its bond buying, the ECB will quite possibly begin its own QE program.

For New Zealand, a European QE program would not be an economic game-changer, given that the linkages between our economies are not as strong as several decades ago (Europe took only 9.7% of our exports of goods in the year to February for example, compared to 22.4% to China). But, if the policy led to stronger growth, for an area comprising 14% of the world economy, that can only help NZ exports.

For financial markets, such a policy would likely strengthen our currency versus the Euro. It would also, we think, add to global investors’ continued optimism for shares, and help keep long term interest rates globally from rising too quickly.

David Lewis

Portfolio Manager