The European Central Bank’s step into the world of zero interest rates is fueling speculation it may eventually be forced to follow the Federal Reserve and the Bank of England with large-scale asset purchases.
The ECB yesterday reduced its benchmark rate to a record low of 0.75 percent and took its deposit rate to zero, with President Mario Draghi saying the cuts may have only a “muted” economic impact. While deflecting questions about further measures such as quantitative easing, Draghi said “there is no feeling that we are running short of policy options” and “we still have all our artillery ready to contain inflationary risks” in either direction.
“They have practically exhausted their conventional armory,” said Julian Callow, chief European economist at Barclay Plc (BARC) in London. “Cutting the deposit rate to zero has practically brought them to the door of QE, even though that is not what they may have intended.”
The ECB’s rate cuts came within 45 minutes of China lowering borrowing costs and the Bank of England restarting its asset purchases, adding to a new round of global monetary stimulus. With Europe’s debt crisis curbing growth across the continent and damping the outlook for the world economy, the ECB was under pressure to ease policy even though Draghi last month voiced misgivings about the effectiveness of a rate reduction.
“It’s clear that when demand is weak, the transmission of price signals to the aggregated economy is muted,” Draghi said. The rate cuts will reduce the cost of the more than 1 trillion euros ($1.24 trillion) in ECB loans to banks, he said.
The euro fell more than a cent to a one-month low after Draghi spoke and traded at $1.2375 at noon in Frankfurt today. European stocks declined. The Stoxx Europe 600 Index (SXXP), which closed 0.2 percent lower yesterday, fell a further 0.2 percent today.
Unlike the Fed and the Bank of England, the ECB has never engaged in QE. When it bought government bonds in its comparatively modest program, it sterilized the purchases to avoid fueling inflation. That measure was shelved earlier this year, and Dutch council member Klaas Knot said in a magazine interview published this week that it will remain “fast asleep.”
‘There Are Limits’
Some ECB policy makers opposed the purchases, arguing they blur the line between monetary and fiscal policy by reducing borrowing costs for specific governments. If the ECB were to engage in QE to expand its balance sheet and swell the money supply, it would likely involve buying a wider range of assets across all euro-area debt markets.
“There are limits to what we can do,” ECB Executive Board member Joerg Asmussen said in a speech in Brussels today. “There should be no illusion that the ECB can single-handedly ensure a plain sailing for our economies and the markets. The ECB cannot compensate for what others -- notably political authorities -- fail to do.”
Draghi said there was “no discussion of further unconventional measures” at yesterday’s policy meeting. “I can’t see that there are measures that are effective in a highly fragmented market,” he said.
Yields on Spanish 10-year bonds, which fell after euro-area governments last week took steps toward a closer economic union, jumped more than 30 basis points to 6.77 percent as Draghi spoke and rose to 6.98 percent today. The Italian equivalent increased to 6.05 percent. That compares with 10-year borrowing costs of 1.37 percent for Germany.
“The euro area is sliding deeper into recession, the bond markets are panicking again, but the ECB feels no particular urgency to act,” said Marchel Alexandrovich, an economist at Jefferies International Ltd. in London. “A further cut in the main refinancing rate seems likely next month, but overall, another disappointing response from the ECB.”
By cutting its deposit rate to zero, the ECB may encourage banks to lend to other institutions, companies or households instead of parking excess cash in its overnight deposit facility. About 800 billion euros is currently being deposited with the ECB each day.
Still, “it is difficult to foresee what banks will do,” Draghi said. “I don’t expect banks’ behavior to change dramatically in any way.”
Latest data suggest the euro economy is heading for a recession. Unemployment rose to a record 11.1 percent in May, economic confidence slumped to the lowest in more than 2 1/2 years in June, and services and manufacturing output contracted for a fifth month. The 17-nation economy will shrink 0.3 percent this year, according to the European Commission.
“We still expect a gradual, slow recovery around the end of the year,” Draghi said. “The baseline scenario hasn’t changed, although the downside risks are now materializing.” Inflation may drop below the ECB’s 2 percent before the end of the year, sooner than previously expected, he said.
ABN Amro economists said in a note to clients that speculation may now build on a QE program. Elwin de Groot, senior market economist at Rabobank Nederland in Utrecht, suggested that such a policy is a logical possibility in a worsening economic environment if the inflation rate does fall faster than the ECB forecasts.
“With its conventional toolbox largely exhausted, this raises the question what the ECB would do if it were suddenly to see downside risks to inflation in future,” said de Groot. “It surely must be some form of QE then.”
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