The ECB’s toolkit looks worryingly limited for tackling euro malaise
THE CLAMOUR for further monetary easing from the European Central Bank (ECB) has become almost deafening. Despite this, the ECB yesterday decided to hold its interest rate at 0.25 per cent. As one journalist at ECB president Mario Draghi’s press conference griped, “Why won’t you simply cut rates!?”
There are two fundamental reasons why the ECB shied away from action this month. First, the data is, at best, mixed. Secondly, it lacks the necessary tools to easily and simply tackle the low inflation environment.
Let us look at the data first. While it’s true that Eurozone annual inflation dropped to 0.7 per cent in January, this was predominantly driven by food and energy prices – seen as temporary shifts driven by global markets and out of the ECB’s control. There is a long-term downward trend in inflation, but the ECB feels it has already accounted for this given that little has changed in core inflation since October. Draghi himself stressed that this is a “complex situation”. The Eurozone manufacturing sector posted its strongest rate of expansion since May 2011 in January, but at the same time private sector lending declined by 2.3 per cent at the end of 2013. Throw in jitters around emerging markets and the Fed taper, and the outlook is indeed confused.
While this is understandable, the second issue is more concerning. The ECB insists it has numerous tools at its disposal. While a few spring to mind – an interest rate cut, asset purchases, a negative deposit rate or further long-term loans – none of them looks particularly appealing when it comes to tackling the low growth and low inflation problem.
A rate cut could signal an easing bias, but given that rates are already so close to zero and the transmission mechanism remains broken, it would have a limited impact. A negative deposit rate is unprecedented and could have the perverse effect of forcing banks to hold more cash, cutting down excess liquidity in the Eurozone. This could hurt rather than help lending.
Long-term loans would certainly make the system flush with liquidity again, but the previous rounds failed to filter through to the real economy and are being repaid rapidly. Targeting them to encourage lending is tricky when the ECB already offers unlimited short-term loans at very low rates.
Finally, there are asset purchases – possibly the most controversial of all. If the ECB were to purchase government bonds, it would have to be spread proportionately around the Eurozone. This could drive rates lower in the core and is unlikely to channel enough money to the periphery. Purchases of bank loans looks a more realistic option. But the market for these is messy and opaque across Europe. This makes them very hard to price and means a substantial risk transfer to the ECB. Both forms of asset purchases would also risk eroding support in Germany, further exacerbating north/south tensions in the Eurozone.
All that said, the ECB’s easing bias seems intact and further action is likely in the coming months. But the ECB has few good options. Investors should adjust their expectations accordingly.
Raoul Ruparel is head of economic research at Open Europe.