The big news of the day is the meeting of the European Central Bank (ECB). President Mario Draghi unveiled a number of measures to try and combat building deflationary pressures in the eurozone.
What’s the Problem?
The immediate issue the ECB is trying to fight is deflation. Earlier this week we found out that month-over-month CPI inflation in May was flat while the year-over-year change was just +0.5% (chart below). This is well below the ECB’s target of 2%.
Central bankers in all the major developed economies are worried that outright price declines would prove to be toxic for today’s modern (and leveraged) economy. Europe is the closet to experiencing outright deflation, in part because the euro has been relatively strong. A strong euro has pushed down import prices (see chart below), and this is feeding through into the real economy.
In addition to deflation, unemployment remains a major problem. Unemployment in the entire eurozone totals 11.7% while in Italy, for example, youth unemployment is running at 43.3% (as you can see below).
And finally there is the issue of borrowing rates. While government bond yields have fallen significantly, rates on business loans have not fallen anywhere near as much, particularly for peripheral businesses (in Italy, Greece, Spain, etc.). The chart below shows the rate charged on small-and-medium sized business loans in both the core countries (Germany, France, etc.) and peripheral countries. This large gap is hampering borrowing in peripheral countries.
What Did They Do?
For once the ECB was pretty bold in their moves. They cut two key interest rates:
– Refinancing rate was cut from 0.25% to 0.15%
– Deposit rate was cut from 0% to -0.1%.
– In addition to the cuts Draghi repeated the ECB’s pledge that those interest rates will remain low for a considerable period, and “possibly for longer than previously seen.”
The negative deposit rate is the first time a major central bank has cut rates below zero. Essentially the ECB will be charging banks for keeping deposits with them. Their goal is twofold. First they want to encourage banks to increase their lending. However, it’s doubtful this will have much of an impact, as George Magnus in the FT noted this morning:
“Negative deposit rates are the novel part of the package, but their effectiveness is questionable. European banks’ deposits at the ECB have fallen close to zero in the past several months, and their reserve holdings at the ECB, to which negative rates will also apply, have also diminished significantly. The negative interest rate, therefore, is unlikely to have a significant effect on banks’ behaviour.”
Our best guess is that the ECB’s goal with the negative rate is to drive the euro lower, or at least halt its appreciation. Denmark is one of the few other countries to try negative rates. They did it in part to preserve their currency peg with the euro. As you can see below, once negative rates were introduced (vertical solid line) the currency weakened noticeably.
Probably just as important were the other policy initiatives:
– The ECB will offer cheap long-term loans, know as targeted longer-term refinancing operations (TLTROs). Under the program eurozone banks will be able to borrow up to 400 billion euros from the ECB to fund household and business loans.
– The ECB will also no longer “sterilize” their actions. This means they will allow their balance sheet to grow over time. This is another way of saying they will allow the money supply to grow as they pump money into the banks.
– Draghi said the ECB was prepared to buy asset backed loans if regulators would allow that market to grow. This point is important in driving down borrowing costs and encouraging bank lending. Asset backed security issuance (ABS) has fallen off a cliff in Europe due in part to regulatory changes. This is really hampering bank lending because loan growth is now tied directly to capital growth.
– Finally, Draghi stated in the press conference that ‘…we aren’t finished here.” He noted that “A broad-based asset-purchase program is certainly one of those instruments,” the bank could use down the road.
If anything this last point is the most important from a sentiment standpoint. There were justifiable fears that the ECB would underwhelm today, as they have so many times before. If anything the statement above exceeded expectations and reinforces Draghi’s comment many months ago to “do whatever it takes.”
Will it Work?
It depends on how we define work.
– Will it encourage bank lending? Questionable. The negative rate is essentially a tax on the banks that in all likelihood will be passed onto consumers. It’s hard to see how this will encourage lending.
– Will inflation pick up? More likely. The euro’s path over the next few months will govern this. Simply halting the euro’s rise will be something and help stabilize the inflation data.
– What about investor sentiment? Positive. Our bet is that the ECB’s actions will be seen as positive for the markets and modestly positive for the real economy. The promise to do more will ‘keep faith alive’ and we suspect the markets continue their grinding advance as a result.