What monetary policy for a weak and uneven recovery?
Is the ECB reaching the limits of its tools?
The ECB announced further monetary stimulus but disappointed markets (see Mario Draghi’s opening Statement). It cut its deposit facility rate by 10 bps to -0.30%. Mr Draghi highlighted the effectiveness of the deposit rate cuts for “enhancing the power of [the ECB’s] transmission channels” and lowering the cost of credit. However, Alberto Gallo (RBS Silver Bullet) highlights that the fall in borrowing costs has been uneven across sectors and countries, with a still wide core-periphery gap, and that lending volumes remain stagnant. Lower interest rates can hurt bank profitability and erode capital, as explained by the BIS. The main channel of transmission will be the exchange rate. The main refinancing rate (0.05%) and marginal lending rate (0.30%) were left unchanged.
Other key changes announced are as follows:
Expansion of the asset purchase program to March 2017 or if necessary, beyond that. The size of the purchase program was left unchanged at €60/month.
Principal payments on the securities purchased would be reinvested as they mature, for as long as necessary. But this would simply maintain the size of the ECB’s balance sheet and not expand it.
Euro denominated marketable debt instruments eligible for purchase would now include debt issued by regional and local governments in the euro area.
The central bank will continue conducting MROs and LTROs as fixed-rate tender procedures with full allotment at least until 2017.
The central bank also revised its inflation forecasts slightly lower from the September 2015 estimates, to 0.1% in 2015, 1.0% in 2016 and 1.6% in 2017. The ECB will also take into account the long period of inflation overshoot in future policy decisions, which means that price level targeting “may be the next big debate” (Eurointelligence). For Citi, further easing is likely through two more deposit rate cuts (taking it to -75bp in 2016), a further six-month extension of purchases, and probably by a step-up (+€15bn) in monthly purchases.
ECB Board Members were divided over the decision. As reported by Barclays, 5 Governing Council members (Bloomberg) were against the measures and Bundesbank head Weidmann saw no further need for additional stimulus. Holger Steltzner (FAZ) criticizes the ECB for failing to take responsibility for its redistribution policy, which drives up prices on assets hold by wealthy people, while the middle class no longer benefits from its savings, and which redistributes loans and liabilities between countries.
Markets reacted with a sharp deterioration. The main “disappointment” is the size of QE2 and the lack of a step-up in the monthly pace of asset purchases. Scott Evans (Discovery Capital) sees a real risk that Draghi’s credibility will take a hit. Bond yields climbed with some of the largest moves in recent years. Alberto Gallo (RBS Silver Bullet) notes that investors are excessively positioned based purely on central bank actions (Why QE won’t work and how to fix it).
The ECB’s decision had spillover effects. The Danish central bank, which targets the exchange rate, left rates on hold following ECB rate cut. The SNB is also expected to hold-off from cutting its own interest rate instruments (see here).
…And implications for global imbalances. Policy divergence between the US and the EZ and economic transitions such as China’s, will make Europe the center of the global saving glut (Financial Times). George Saravelos’ “euroglut” theory becomes a reality, as American and Asian investors move away from European assets while Europe exports its savings overseas, leading to a fall in currency reserves held in euro. According to Credit Suisse, negative deposit rates have triggered these outflows, as part of a currency weakening gambit to regain competitiveness. The recent introduction of the RMB in the IMF’s SDR comes at the expense of the euro (and the pound), although Krugman argues that this change is mainly symbolic.
… With a cyclical but uneven recovery
The EZ is showing signs of a ‘’cyclical recovery’’ (Nouriel Roubini), with indicators such as credit creation starting to pick up, as noted by Angel Ubide (Peterson Institute). He stresses however that the levels of activity, inflation, and inflation expectations remain low, while unemployment remains very high (Xavier Timbeau). Spain illustrates the EZ recovery with increasing national demand, full time employment, investment, and government spending. Nearly all the country’s sectors are contributing to GDP and creating jobs (Eurointelligence)—in contrast with the Greek situation.
Ambitious proposals and structural reforms will eventually result in higher potential and actual growth (Nouriel Roubini). But a number of challenges within and outside the EZ might compromise an already sluggish recovery.
The weak demographics and low investment twosome (Michael Heise in Project Syndicate)—which fiscal and monetary policies will not be sufficient to address. Productivity growth remains weak in advanced economies (Gavyn Davies). Another issue may arise from “seeping pessimism” in the EZ (Financial Times).
Lack of integration—a point stressed by Colm McCarthy. For Wolfgang Munchau, European leaders need to “ringfence the eurozone” and provide the euro more political support. But the EZ faces a “fundamental contradiction” resulting from (i) the need for considerable integration at the EZ level and economic discipline at the national level, and (ii) EZ residents’ preference for national democracies over a Eurozone government. The required integration for a stable monetary union is difficult to achieve (Nouriel Roubini). But is further integration necessary? Christian Odendahl argues in favor of further integration where it is “economically essential”, stating that as much as possible should be left to member-states. However, the governance changes he suggests are difficult to carry out without a federation, so the EZ will require one eventually (Eurointelligence). Peter Bofinger argues that a EZ narrative that does not account for the German Wage Moderation is incomplete, as it helped Germany face the crisis (Simon Wren-Lewis) as a replacement for devaluation (Decressin and Loungani) but caused imbalances within the EZ and prevented the ECB from increasing its policy rate to counter overheating in deficit countries prior to the crisis.
The institutional policy response is driven by the European Commission. It opened the 2016 European Semester (see fact sheet for details) with the publication of the 2016 Annual Growth Survey, with three priorities:
Re-launching investment. Improving the regulatory environment; completing Banking Union and building CMU; addressing the debt overhang and NPLs (incl. insolvency laws); greater focus on human capital investment.
Structural reforms. Fostering productivity growth and economic convergence; labor market reforms (“flexicurity”); greater competition in product and service markets.
Growth- and equity-friendly fiscal policies. Growth-friendly consolidation where needed; tax system reform to incentivize job creation; modernizing social protection.
The Alert Mechanism Report identified risks of macroeconomic imbalances for 18 countries, with follow-up and first-time reviews, and economic policy recommendations for the euro area. Alongside, the EC published the draft Joint Employment Report and analysis identifying the main challenges to investment in each EU country. It also issued a legislative proposal to extend the newly created Structural Reform Support Service beyond 2016. The annual SME performance review stressed the importance of SMEs, which in 2014 accounted for 71 percent of new jobs in the EU’s non-financial business sector.
The Short View: Clean energy is an investment opportunity for Europe, according to Xavier Timbeau. Contributing to the European Commission’s energy union, Bruegel scholars state that innovation in low-carbon technology can be encouraged via (i) carbon pricing, (ii) supporting the “as-yet uncompetitive technologies”, and (iii) supporting research and development. This is crucial as economists argue that consumers might not adopt costly measures.
