FRANKFURT/PARIS The European Central Bank's drip-feed stimulus is taking it closer to large-scale government bond purchases with new money but its weapon of last resort may not be the silver bullet markets are hoping for.
After a policy meeting on Thursday, ECB President Mario Draghi said the ground was being prepared for "further measures to be implemented, if needed".
Sources close to the ECB have told Reuters that its current plan to buy private-sector assets may fall short and pressure is likely to build for bolder action early next year, firstly moving into the corporate bond market.
While some euro central bankers are opposed in principle to taking the ultimate step - quantitative easing - others are hesitant because there is no guarantee it will revive the euro zone economy.
"We call it peeling the QE onion," said Andrew Bosomworth, a senior portfolio manager at Pimco, the world's largest bond investor. "It makes a few members of the Governing Council cry.
"The ECB is trying all these different tools to prevent deflation, but if they fail, what's left is only one tool – sovereign QE."
The hurdles to such a step remain high.
There is a minority on the Council of at least seven, possibly up to 10 of the 24 members opposing such a step at least for now, central bank sources told Reuters.
Japan accelerated its government bond purchase programme last month on a 5-4 vote. That may work for a single state, but would be fraught in the 18 soon 19 member currency union.
"Given the opposition in Germany, Mario Draghi would want a strong majority on the Governing Council to announce a large and credible QE programme," said Greg Fuzesi, economist at JP Morgan.
Money market traders gave a median 50 percent chance of ECB sovereign debt purchases, with a majority of those saying it would most likely happen in the first half of 2015.
MORE DIFFERENCES THAN SIMILARITIES
The ECB would be the last of the major central banks - after the Federal Reserve, Bank of Japan and Bank of England - to turn to QE and there are reasons why it may be less effective, not least because it would be a programme for many countries not one.
It is expected that the ECB would have to purchase bonds according to its capital key - buying in proportion to the size of member states' economies.
As a result, Germany, the country that least needs help, would get the most. Furthermore, with the exception of Greece, government borrowing costs are already low across the euro zone.
The Fed's massive asset purchases pushed down long-term interest rates, easing refinancing conditions for companies and allowing homeowners to refinance their mortgages, while higher stock prices boosted spending as people felt richer.
But most European companies rely on bank funding rather than the markets and European stocks are already trading at high valuations.
European shares are trading at 13 times their estimated 12-month forward earnings. When the Fed launched its first round of QE in late 2008, U.S. stocks traded at just below 10 times.
Even if the ECB were to buy billions of euros worth of government debt from banks, some are still repairing their balance sheets and all face tougher capital rules, limiting their ability to lend to businesses and households which may feel too gloomy to want more credit anyway.
"The fact that Draghi has been so successful in supporting markets to date with other methods (means that) the incremental benefit from large-scale QE is probably more muted," said Simon Smiles, Chief Investment Officer at UBS Wealth Management.
"We can't just take the same template we saw in the U.S. and Japan."
Similar to Japan, the main channel through which QE would work in the euro zone would be the currency.
The euro is down more than 11 percent against the dollar since May and analysts expect it to fall further as the U.S. economy is now strong enough to be taken off the Fed's life-support measures.
"It may take QE to get the euro down sufficiently to support growth in the euro zone," said Mark Zandi, chief economist at Moody's Analytics.
But there is concern among some euro zone central bankers that pushing the euro down too hard may cause discomfort across the Atlantic.
So far, Washington seems more concerned about the euro zone slipping into deflation and has urged the ECB to take more aggressive steps to revive the economy. That may change if a too strong euro devaluation hampers its own recovery.
A lower euro should push up inflation through higher import costs and a rise in exports, though the former will be constrained by the ability of companies to pass on higher input costs to their customers and the latter may suffer from a slowdown in China, one of the euro zone's top three trading partners.
The recent surprise move by the Bank of Japan also pushed the yen down against the euro, making it harder for euro zone companies to compete with their Japanese peers.
Even Draghi acknowledges that QE in the euro zone would be a unique situation.
"We should be aware that the effects of QE are different depending on the initial conditions," he said on Thursday.
(Additional reporting by Vincent Flasseur, editing by Mike Peacock)