Friday, June 6, 2014

The ECB delivers

The only surprise in the decision by the European Central Bank (ECB) to ease monetary conditions further today was they did everything they could (at least at this point in time).  That included interest rate cuts, a 400 billion injection of liquidity via a targeted long-term refinancing operation (TLTRO) and ending the sterilisation of the central bank’s earlier purchase of government debt.

The interest rate reductions have taken the ECB into uncharted territory.  Along with a cut to the in the refinance rate to 0.15% the Governing Council also lowered the deposit rate to -0.1%.  A negative deposit rate means banks will now pay the ECB to hold deposits at the central bank rather than receive interest.  ECB President Mario Draghi intimated this is probably it for interest rate reduction by stating “For all practical purposes, we have reached the lower bound”.

As you know we have been less than optimistic about the ability of lower interest rates to make much difference in the Euro zone.  That makes the other measures more interesting.  Of those the TLTRO seems to have the best chance of making a difference.  We know from earlier comments that Draghi found the Bank of England’s Funding for Lending program  somewhat compelling, so it is no big surprise to see a similar program from the ECB to encourage banks to increase lending to the private sector.  There is a difference between the two however: the ECB program excludes household mortgages.

Of course higher credit growth requires both a lender and a borrower.  While credit availability will now be improved, there needs to be sufficient willingness from the private sector to borrow and invest.  That remains to be seen and will ultimately determine the success or otherwise of the program.

It is also not altogether clear whether banks will be able to invest in sovereign debt although Draghi stated in his Q&A session that the ECB was “determined that the TLTRO money is not spent on sovereigns”.

The ECB has also decided to end the sterilisation of their earlier purchases of government debt under the Securities Markets Program which began in 2010.  The decision to end sterilisation makes it a "delayed” quantitative easing program.

More important than the small size of the program is the fact that all of today's measures were endorsed unanimously by the Governing Council, which includes the Bundesbank.  That seems to open the door a little wider to full scale quantitative easing should it be required further down the track.  It always seemed to me the support (or lack thereof) from the Bundesbank would be a major hurdle for QE.

Finally, the Governing Council has undertaken to progress the work required in preparation for outright purchases of asset backed securities.  This is a clear signal to the market the ECB is prepped to do more should it be required.

So will any of this make a difference?  The fundamental problem in the euro zone is economic growth is insufficiently robust to make any serious dent in the significant degree of spare capacity that exists across the euro area.  Today's measures are a step in the right direction in avoiding outright deflation, but seem unlikely to change the outlook from one of subpar growth and below target inflation into the foreseeable future.  A more comprehensive quantitative esaing program remains more than likely.  But there is, after all, only so much monetary policy can do.