The euro so far is trading exactly as expected. ECB President Mario Draghi did not disappoint. Yesterday, the refi rate (main lending rate) was cut to 0.15 percent from 0.25 percent and the deposit rate to negative 0.1 percent from zero percent. The overnight interest rate, the Eonia rate, tends to remain sandwiched between these two, so both the upper and lower bounds have now been reduced. The initial reaction in the currency market was to slam the euro down, but soon, in a true ‘sell the rumor, buy the news’ fashion, shorts covered and buyers piled in. FXE ended the session with a huge reversal. Technicals were – still are – way oversold, so this momentum likely continues – at least in the near-term.
But the bigger question is, what is the medium- to long-term impact? What would this unprecedented move by the ECB signify? This is the first time a major central bank has pushed rates on bank reserves into negative territory. What are the repercussions?
First and foremost, it is one more example of a central bank acting out of desperation and belief that monetary policy is an answer to all ills. Since the 2007/2008 crisis, one after another major central bank – be it the Fed, the Bank of England or the Bank of Japan – has fallen victim to this line of thinking. Not much attention has been paid to structural reform, particularly on matters relating to debt, and that needs to be dealt with politically. But so long as monetary policy provides a buffer, politicians do not have an incentive to act.
The ECB action makes one thing crystal clear: the euro-zone debt crisis is far from over. In order to boost liquidity, it plans to stop sterilizing its previous bond purchases under the Securities Market Program; this will increase excess reserves. At the same time, the persistently compressed spreads in the bond market tell us otherwise – that the problem was yesterday’s and better days are ahead. Who is right?
The goal is noble. By driving the deposit rate into negative territory, the ECB is seeking to spur lending. Would it be enough? Time will tell, but it is not etched in stone. The fact that it had to resort to this tactic at all is a sign that the monetary mechanism is broken. Banks are also under pressure to shore up capital. Deutsche Bank yesterday announced it would sell roughly 300mn shares in a bid to raise capital.
Banks will also be allowed to borrow up to seven percent of their loan books for up to four years. Once again, the goal is the same – encourage lending. Unlike in, let us say, the U.S., euro-area corporations for the most part go to banks for loans and rely less on the bond market. Here are a couple of possible scenarios. First, banks will probably try to avoid the stigma of having knocked on the ECB’s door; shareholders probably would not like that either. Second, the real issue is that of end-demand. There is just too much debt in the system, and the problem of leverage cannot be cured by piling on more debt. Throughout most of the developed world – be it the U.S., Japan or the U.K. – the primary issue is out-of-control debt. In the euro zone, unemployment is at record highs, and this suppresses wages and spending, which in turn gives less reason for banks to aggressively lend.
Even though the ECB does not openly admit it, but in an effort to boost exports, it is clearly seeking to drive the euro lower. Here is one risk. Following on the footsteps of the Fed, it is trying to have investors get on the risk curve as well as go down the capital structure. If it succeeds, then that is bound to attract money flows into Euro assets. And that puts upward pressure on the euro. Unproductive nations particularly in the periphery already find the current exchange rate uncompetitive.
A weaker currency also helps raise inflation through higher prices for imported goods. Early in the week, euro-area inflation weakened to 0.5 percent in May (from 0.7 percent in April) – its lowest level in more than four years and below the ECB’s medium-term target of just below two percent. An inflation this low is never good from the perspective of a debtor entity. The periphery countries in particular would love to see their debt load inflated away.
If all these new measures do not produce the desired results – odds are very high that they would not meet expectations – then what is going to be the next step? Draghi has hinted that, should there be a need, he has other tools. The only thing probably left for him to try is full-scale purchases of government bonds. And for that to happen, the Bundesbank needs to give the nod. At the current interest and exchange rates, the German economy is doing just fine. A lower interest rate is likely to overheat that economy. Truly, in a system in which there are so many nations involved, what is ideal for one economy is not necessarily so for another. And that is the crux of the problem behind the euro zone experiment.
In the meantime, Draghi and team are desperately carrying out another experiment – whether an unconventional monetary policy can do away with the ups and downs of a business cycle, or whether there is no such thing as too much debt for an economy to be able to grow out of. Bound to fail, this experiment, sooner or later.
