The title to this write up might seem a little strange, but in light of the recent leakage of information from the ECB regarding the announcement that is due tomorrow, I thought a brief explanation on what it is to "sterilize " in economic terms.
First, it must be said that at this stage the information is still to be confirmed by an official statement that will be made by the the President of the ECB, Mario Draghi, tomorrow (at 14:30 GMT +2). Therefore the information that has leaked prematurely is then to be treated as a rumor. Even so, it would help if we understood roughly what the information meant.
So, rumor has it that the ECB has a plan that pledges unlimited, sterilized bond buying that they hope will help flatten the yield curve. What this means in plain English is that the ECB is willing to buy bonds with shorter (1 to 3 year) maturities, but do not want to increase the money supply in order to do it. In other words, the money that they create, or print, in order to buy these bonds will not be made available in the economic system.
So what I assume they plan to do, is make use of repo (repurchase) transactions in order to "tie up" the newly created cash. So, they buy bonds in exchange for cash, but then immediately have that cash deposited back with them and they give the bonds back to whom they bought them from with idea of swapping back at a specified date in the future. Thus preventing the cash from entering into the economic system and in a sense, preventing Quantitative Easing and ultimately, inflation.
That sounds confusing, so I will try again. The ECB buys bonds with money that they created anew. This brings down the yields on the bonds. The ECB then borrows, the money that they just created and spent on these bonds, back from the parties (sovereigns and banks) that they had given it to. This helps them combat the inflationary pressures that come from adding more and more money to the economy, ie. increasing the money supply.
For them to borrow the cash, they need to give something as security for their loan, so they give back the bonds that they just bought with the commitment to swap back at some point in the future. The entire deal has an expiry date attached to it when the ECB will repurchase (hence called a repo) the bonds from the parties they borrowed the money from. When this date arrives, the deal is probably going to be rolled over for another few years (and probably indefinitely), but the interest cost of the deal is now lower, as the bonds yields are lower, thus lightening the debt burden on sovereigns and banks.
It's a fancy smoke and mirrors show where the ECB can aid sovereigns and banks without actually doing anything. What they don't mention though is that there is long term fallout that this wonderful form of market manipulation causes, which comes in the form of a very low, or zero, deposit rate. This causes a few problems, so I will only mention one: people who are retired and are living off their cash savings, don't earn any interest and eventually run out of money. So a few years down the line, governments will be faced with a increasing elderly poor that are in need of social grants to survive. The cost attached to this is hard to quantify. In a sense, all they are doing, is delaying the debt problem for another day.
