Last week the ECB decided to lower its benchmark interest rate, the main refinancing rate, to a fresh record low of 0.25%, due to “further diminishing underlying price pressures in the euro area over the medium term”. The prior week saw October’s preliminary inflation reading falling to just 0.7pc from 1.1pc in September with the much watched core index (excluding food and energy) of consumer prices sliding to 0.8pc from 1pc. With rates near rock bottom and the economic picture in Europe hardly improving, is the ECB running of room to manoeuvre?
The simple answer is yes. With the ECB left with only one more cut of the headline interest rate (which is likely to be just as ineffective as the current cut proves to be), most commentators are pointing to a further LTRO or a cut in the deposit rate to negative territory. In fact, Peter Praet who is the ECB’s Economics Chief even hinted this week that asset purchases may be on table- similar to what’s been conducted in the U.S., U.K. and Japan.
Looking at the LTRO option, of which there have been two already, it is clear that a third operation (unsurprisingly?) would do very little to solve the problems in the European banking system. The fragmentation in the credit markets that has persisted and the LTROs to date have merely led to banks in the periphery buying up even more government debt whilst reining in lending to the real economy (as assets on balance sheets have deteriorated further).
In Italy, this has played out as such with the bank sovereign ‘doom loop’ intensifying over the past two years. Note that, despite continued balance sheet contraction, banks in Italy (and Spain) have been the slowest in terms of paying back these loans to the ECB. This highlights how ineffective a further LTRO would be in terms of countering the deflationary spiral which is now underway in the Euro-area.
Reducing the interest paid on excess reserves at the ECB below the current rate of 0pc has been muttered for a while with many officials stating that the ECB is “technically ready” to implement such a measure should a consensus be reached.
The intention would be for the ECB to reduce the deposit rate into negative territory in order to effectively punish banks’ holdings at the ECB in order to spur lending. Think of it as increasing the opportunity cost of not partaking in potentially profitable origination activities. Support for this policy has gathered steam this year amidst ever greater credit contractions in the periphery. That said, as recently as 2011 the ECB had in fact been warning of the dangers of conducting such a policy, citing dangers to the wider money market.
Naturally this policy move would also prove useless in stimulating lending activities as banks would move to accelerate LTRO repayments in order to reduce their excess reserves at the ECB. This would likely put more upward pressure on the Euro as the ECB’s balance sheet shrinks further exasperating the Franco-German split inside the Eurozone. The point is that if banks wanted to lend to companies in the periphery, they would to so whether the deposit rate was 0pc or -0.25pc. Indeed it could even be argued that a negative deposit rate could actually raise lending rates as banks seek to cover the extra costs of holding reserves with the ECB.
The final option is outright asset purchases which has been floated this week whereby the ECB would likely buy up various Euro-area government bonds. Whilst this is mere speculation at present, it is clear that any movement on this front would face severe opposition from Germany. For Germany, one must consider the possible legalities of such a scheme with respect to its constitution as well as fronting up to German public opinion which was opposed to the ECB’s recent rate cut and last year’s mysterious OMT announcement.
What’s clear is that the options are running out for the ECB whilst the economies of Europe struggle to recover amidst disinflation – or in some parts outright deflation. What needs to be understood is that monetary policy has now virtually exhausted its toolbox and that the pressure must be put on governments to step up the reform effort – something that is a painfully slow process in Europe (See Greece). But moreover, any sustainable solution to the mess in Europe seems impossible with the current bloc of 17 diverse countries sharing a single currency with no common political and fiscal platform. Things will get worse before they get better.