It Will Take More Than ECB Rate Cuts for the Eurozone to Fully Recover
The European Central Bank’s (ECB) surprise rate cuts on Sept. 4 — reducing its main lending and deposit rates by 10 basis points — show that its policies so far have been inadequate to solve the euro-area’s economic malaise. Economic growth has stalled, and deflation remains a threat in the eurozone. The rate cuts may help to weaken the euro further in the currency markets, but nobody should be under any illusion that banks will start lending or expanding their deposits as a result of the rate cuts alone, or that these cuts will trigger a wider economic recovery.
The key part of the announcement was the statement by ECB President Draghi that the ECB will begin purchases of asset-backed securities (ABS) and covered bonds in October. Without specifying the size of the asset purchases, he said that this would have a “sizeable impact” on the ECB’s balance sheet. However, I see several issues that will need to be addressed:
- The ECB is apparently still unwilling to buy government and corporate bonds in a full-scale quantitative easing (QE) program.
- The scheme needs to be well designed (unlike the previous LTRO program, which failed to increase commercial bank lending). That means the purchases must be mainly from non-banks — not, as he specified, confined to “claims against the euro-area non-financial private sector.”
- The program needs to be very substantial in scale — at least EUR 2 trillion in size, perhaps spread over a year or two years. However, this is far greater than market expectations. Currently there are few existing ABS that the ECB is willing to buy. Hence the size of the program is unlikely to be large enough.
To be fair, a full-scale QE program has not been entirely ruled out, and Mr. Draghi mentioned that there were some Governing Council members who wanted to do more (i.e., start QE). But the ECB is a slow-moving, consensual organization. It will take many months of continued economic weakness — and perhaps even the emergence of true deflation across the eurozone as a whole — to force the Governing Council to act. Sadly, precious time is being wasted.
For the equity markets there may be enough enthusiasm about the prospects of ECB action to keep asset prices buoyant, but markets cannot live on hope (or Mr. Draghi’s promises) alone. The ECB will need to enlarge substantially the size of its balance sheet. Meantime, based on its Sept. 4 announcements, initially the most benign effects are likely to be on the currency (weakening the euro relative to competitors), and in the bond markets of the periphery (helping yields to decline even further). Longer term, unless real growth and nominal growth both revive, investors may start to look to asset classes and markets with better fundamental prospects elsewhere.
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