The European Central Bank may be running out of options it can stomach.
With the euro area assailed by spreading recession, financial-market instability and political impasse over the direction the single currency should take, ECB President Mario Draghi yesterday stressed the limitations of his current policy tools, from standard interest-rate cuts to bond-buying and liquidity injections. Moves such as quantitative easing or capping bond yields to calm markets remain taboo for the ECB, which says its main job is to ensure stable prices.
“It’s clear that they are very low on, if not completely out of, ammunition,” said Nick Kounis, head of macro research at ABN Amro in Amsterdam. “There are options that would have a more significant effect, but they’re outside of the ECB’s comfort zone. There’s an element of helplessness.”
Having already cut its benchmark rate to a record low of 1 percent, injected more than 1 trillion euros ($1.2 trillion) of three-year loans into the banking system and bought 212 billion euros of government bonds, the ECB is reluctant to do more heavy lifting as governments procrastinate over the reforms it deems necessary to put the monetary union on a sustainable footing. Draghi questioned the effectiveness of cutting rates further and flooding financial market with even more liquidity.
‘Ready to Act’
Draghi said the ECB stands “ready to act” should the debt crisis damp the euro-area economy further, and that “a few” Governing Council members pushed for a rate reduction at yesterday’s policy meeting.
Still, “we have to be aware that the context is one where you have liquidity constraints and tensions in financial markets,” he said after keeping rates on hold. “Price signals in this situation have a relatively limited immediate effect.”
Draghi also cast doubt on the impact of further longer term refinancing operations, or LTROs, saying the full effects of previous loans have yet to be felt. Some of the problems in the euro area “have nothing to do with monetary policy,” he said.
“Whether they cut interest rates or not, it won’t have much of an impact,” said Uwe Angenendt, chief economist at BHF Bank AG in Frankfurt. “On the liquidity front, the banking sector is already oversupplied. The ball is in the court of political players. It’s not for the ECB to fill this vacuum.”
Investor concern about political inaction pushed the euro to a two-year low against the dollar. At least eight of the 17 euro nations are in recession.
Still, European stocks climbed and Spanish bonds rose today. The Stoxx Europe 600 Index’s gained 0.3 percent to 240.58, extending yesterday’s biggest rally in six months, amid speculation global policy makers will take steps to revive growth. U.S. index futures and Asian shares also advanced. Spanish bonds rose for a sixth day before the nation auctions as much as 2 billion euros of debt.
The ECB may be reluctant to cut its benchmark rate much further because it poses the question of whether to lower the deposit rate from 0.25 percent. That has served as a floor for market interest rates since the ECB began providing banks with unlimited liquidity in 2008.
Cutting the deposit rate close to zero may reduce the incentive for banks to lend to each other at a time when they are already wary of each others’ balance sheets. At the moment, banks park money with each other at an overnight rate of 0.31 percent, according to the European Banking Federation. The risk is that a rate cut will push those overnight rates so low that banks will chose just to leave their cash with the ECB. That in turn could freeze money markets, the very phenomenon the ECB is trying to avoid with its full-allotment policy.
Cutting the benchmark rate to a new record low would also put the spotlight on the ECB’s other policy tools and take pressure off governments to implement reforms, said Ken Wattret, chief euro-area economist at BNP Paribas in London.
“The ECB fears that the minute it cuts rates below 1 percent it will come under huge pressure to introduce more unconventional measures, such as more bond buys and more LTROs,” Wattret said. “I have sympathy as to why they don’t want to do that, because the ECB has really expanded its balance sheet with limited returns. There is definitely a moral-hazard issue there.”
Concern over Spain’s ability to recapitalize its banks has driven up borrowing costs for the government, which is pushing for Europe to channel funds directly to its lenders. Budget Minister Cristobal Montoro used a radio interview on June 5 to call for outside support, saying the sums needed to aid Spain’s banks aren’t “astronomical.”
Draghi repeated the ECB’s call for euro-area governments to “clarify” their vision for the euro area while denying he’s refraining from acting until they deliver.
These are “high-level decisions that concern the future of the European integration and the future of the euro area,” he said. “There’s no sort of horse trading here.”
Draghi has joined European Union President Herman Van Rompuy, Luxembourg’s Jean-Claude Juncker, who leads the group of euro-area finance ministers, and European Commission President Jose Barroso in drafting a program for deeper integration in the euro area. Van Rompuy said on June 4 that he will report on proposed “building blocks” at the next summit of EU leaders on June 28-29 in Brussels.
In the meantime, markets are clamoring for immediate action from the central bank, which said yesterday that risks to the economic outlook have increased.
Draghi “should start by cutting rates to lower the costs of the LTRO and primarily to show the market that the ECB is there, willing to do something,” said Marchel Alexandrovich, senior European economist at Jefferies International Ltd. in London. “The ECB dragging its heels is not a costless exercise.”
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