ECB likely to announce stimulus this week

Faced with falling prices and the risk of another recession, the European Central Bank this week is expected to announce a massive economic stimulus after trying to avoid taking the dramatic and controversial step for more than a year.

Many economists predict the ECB's 25-member governing council Thursday will vote to buy large amounts of government bonds to hold down long-term interest rates and stimulate growth. The program, known as quantitative easing, is similar to Federal Reserve bond purchases credited with jolting the U.S. economy after the 2008 financial crisis. The last round of those purchases ended in October.

A eurozone bond-buying program got a major boost last week when the advocate general of Europe's highest court stated that such an initiative would not violate a prohibition against using monetary policy to finance national budgets. The court typically follows the advocate general's recommendation.

Quantitative easing, or QE, initially is likely to weaken the euro and further strengthen the dollar, hurting U.S. exports. But ultimately what's good for the eurozone economy is good for U.S. multinational firms, and so stocks could get a lift if the ECB finally pulls the trigger, says Lucy O'Carroll, chief economist of Aberdeen Asset Management.

Yet it's much thornier to buy government bonds in the eurozone's fragmented economy with 19 member states than it was in the U.S. Germany is among nations opposed to the initiative, but the measure is still likely to pass, says Barclays Capital economist Antonio Garcia Pascual.

"If they don't do this on Jan. 22, markets will be shocked" and could fall sharply, says Edwin Truman, senior fellow at the Peterson Institute for International Economics and former assistant U.S. Treasury for international affairs.

Ratcheting up the pressure on the ECB to act was a report that eurozone consumer prices fell 0.2% in December, and economists expect several more months of deflation. Although the drop was due solely to plummeting oil prices, a persistent fall in prices can prompt consumers to postpone purchases, leading to further declines and recession.

ECB President Mario Draghi recently told the German daily Handelsblatt, "The risks of not fulfilling our mandate of price stability are … higher than they were six months ago."

The eurozone economy likely grew less than 1% last year, economists estimate, after emerging from recession in 2013.

QE is intended to pump cash into the banking system and hold down interest rates, prodding consumers and businesses to borrow more and fueling economic activity. It also should boost European exports by further driving down the historically low euro, and nudge investments into stocks, making consumers feel wealthier.

Howard Archer, chief European economist of IHS Global Insight says the latter two outcomes are likely. But filling bank coffers with cash is unlikely to coax the many institutions burned in the recession to open the lending spigots, he says.

Also, because of the splintered eurozone economy, pushing down interest rates will likely do far less in countries with already low borrowing costs, like Germany, than in those with relatively high costs, like Spain.

The biggest challenge is figuring out which bonds to buy. German officials oppose buying the bonds of struggling countries such as Spain, Portugal and Italy that could default and leave German taxpayers footing the bill.

But if the ECB buys only top-rated bonds of economically healthy nations, that will do little to help debt-wracked governments and anemic economies, Archer says.

Pascual expects the ECB to initially purchase about $575 billion of the bonds of all member states based on their share of capital in the central bank. He also expects any losses on the purchases to be shared across the eurozone system. Interest rates in struggling countries would spike if their bond losses were borne only by their national central banks, he says.

One wild card is a Greek general election just three days after the ECB meeting. If a new party wins and restructures the country's debt, the ECB likely would exclude Greek bonds from QE. As a result, Pascual says, the central bank could broadly announce the program Thursday and disclose details later.

By lowering government borrowing costs, bond purchases could take pressure off countries to tackle bigger problems, such as cutting deficits and reforming rigid labor and product markets that constrain growth, Truman says.

But the economists agree it's necessary. Archer estimates it will boost the region's economic growth next year by a modest two-tenths of a percentage point to 1.4%. Pascual expects a bigger impact of a half a percentage point to 1.2%.

"I don't think it will be a silver bullet," he says. But, "it should stop deflation from getting worse."