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European QE Is Finally Here, But Will It Work?

|Includes: WisdomTree Europe Hedged Equity ETF (HEDJ)

After months of speculation the European Central Bank finally unveiled the specifics of a rather substantial quantitative easing policy. ECB President Mario Draghi announced that the ECB would buy 60 billion Euros per month. The purchases will include asset backed securities, investment grade national bonds, and government bonds throughout the region. The plan will currently be in force until September of 2016 but Draghi did leave the door open for a continuation of the program until the ECB feels comfortable hitting their 2% inflation target. The big question on everyone's mind is whether this program work?

The fact that Europe is even doing QE is a positive sign that the continent is becoming more coordinated with its actions. The program will involve sharing of risks across Europe of the bond purchases which is a significant step towards a more unified Europe. This has to happen if Europe is to ever pull itself out of this seemingly endless recessionary environment. However, it is unlikely that this program will boost inflation trends across Europe. One of the primary reasons Draghi and the ECB unveiled the program was because inflation expectations have been cascading lower in Europe in recent months. Look no further than the yield on government debt across the region.

A fair comparison is the actions taken by the Bank of Japan over the past few years. The Bank of Japan has been extremely aggressive in its quantitative easing program, expanding its balance sheet by trillions of dollars. Yet inflation expectations haven't seen any substantial uptick. We did see a modest uptick in inflation expectations in the United States but that has obviously tailed off substantially since QE ended. Some of this has to do with the fact that every commodity in the world is settled in U.S. dollars. Therefore, any U.S. QE program will have a greater impact on inflation around the globe than any other global central bank QE program. It also has to do with the fact that when a central bank buys assets, these funds are not necessarily injected directly into the economy.

The net effect of whether the program will be successful or not lies solely in the hands of the European banking system. One of the primary reasons that the European economy has not shown any positive traction is because of the leverage in the European financial system. Banks have poor balance sheets and capitalization ratios relative to U.S. financial institutions. Because of this we have not seen any acceleration in loan growth throughout Europe. If European QE helps to improve the balance sheet of these banks then QE may help the European economy as a whole. At the end of the day this is definitely a step in the right direction, and the coordinated action is welcoming, but on a standalone basis it's unlikely to solve all of Europe's economic problems.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.