How the ECB Plans to Prevent Inflationary Pressures on Bond Purchases

US and European stock markets are soaring once again today, thanks to a grand plan from the European Central Bank to solve the eurozone crisis…once again.

The details of this latest and greatest rescue don’t really matter; it’s all about the headline:

“US Stocks Rise on ECB Bond Plan,” a Financial Times headline declared.

“S&P 500 Hits More Than 4-Year High After ECB Move,” Reuters chimed in.

“Global Markets Cheer ECB Bond Plan,” the Associated Press gushed.

The details of the plan, if you must know, feature the unlimited and open-ended purchase of European government bonds by the European Central Bank (ECB).

But these purchases will not create inflationary pressures, according to the ECB, because it will “sterilize” them. The process may sound savage, but it is really quite civilized — so civilized, in fact, that it is likely to be completely ineffectual.

The ECB sterilizes its purchases by simultaneously selling some other asset on its books. In other words, it buys a few bonds from Petros while selling an equivalent among of securities to Paulo. Sloshing money around in the credit markets, according to the theory, will suppress long-term interest rates and restore confidence in Eurozone government bonds.

Maybe…or maybe sloshing money around in the credit markets will only slosh money around in the credit markets…to no effect whatsoever. Time will well. But for today, the news is “all good, bro.” And the markets are loving it.

According to ECB President, Mario Draghi, the new program, dubbed Outright Monetary Transactions (OMTs), “will enable us to address severe distortions in government bond markets which originate from, in particular, unfounded fears on the part of investors of the reversibility of the euro.”

Again…maybe. But “maybe not” seems the better bet. Because these “unfounded fears” rest on a very substantial foundation of legitimate terror, the new OMT program is unlikely to succeed any better than the previous once-and-for-all ECB rescue programs.

But that’s a problem for another day. For today, investors are feverishly gobbling up stocks, which, as Chris Mayer explains in his essay “The Elephant and the Flea”, is a sharp break from recent trends. For several months, investors have been tip-toeing away from the stock market. Disillusionment seems to be taking hold, as folks like Bill Gross, founder of PIMCO Asset Management, declare that the “cult of equities is dying.”

Ignore them, says Chris. The death of equities is greatly exaggerated. The key is to focus on fleas, not elephants.

Eric Fry
for The Daily Reckoning

The Daily Reckoning