ECB Clearly Worried About Deflation & Growth

The ECB took aggressive steps today surprising markets just how far Mario Draghi went pulling out the big guns after two years of promises. The biggest question is will this really help the European economy rebound. Will this easing reach the man on the streets. Will this stimulus help Italy’s ailing banking system and will this create jobs and growth in Spain and Greece? Many believe it’s too late.

By ‘throwing the kitchen sink’ at the Eurozone’s problems, the European Central Bank may have moved closer to the point where it has to actually start showering cash on the economy.

So argues George Magnus, an experienced City voice who used to be head economist at UBS.

He argues that the market reaction shows investors don’t believe today’s package of interest rate cuts, cheap loans and a beefier asset purchase scheme will work.

Actions taken by the ECB Governing Council to fight downside risks to inflation exceeded market expectations considerably. The package includes rate cuts as well as an extension of the QE program and a new series of targeted longer-term refinancing operations. President Draghi cited the weaker outlook for global growth as well a tightening financial conditions since the December 2015 meeting as the main reasons for today’s decisions. With the new measures in place the ECB hopes a substantially easing of financing conditions. An overwhelming majority of the council members voted in favor of the new set of measures.

Both the ECB main refinancing rate and the rate of the rate on the marginal lending facility were cut by 5 basis points each to 0.00% and 0.25% respectively. Most important, the rate on the deposit facility was lowered by 10 basis points to -0.40%.

A new series of four targeted longer-term refinancing operations (TLTRO II), each with a maturity of four years, will be launched, starting in June 2016. The interest rate under the TLTRO II will be fixed over the life of each operation at the rate on the Eurosystem’s main refinancing operations prevailing at the time of take-up. Under certain conditions, borrowing conditions in these operations can be as low as the interest rate on the deposit facility.

President Draghi emphasized that the Governing Council doesn’t see any need to reduce rates further. Furthermore, rates can’t be taken so slow that they hurt banks. Emphasis will shift more to unconventional tools. Given the bold measures taken today, further policy action in coming six months looks very unlikely.

The ECB is clearly deeply concerned at the threat of deflation, and is betting that this huge injection of cash into the ailing Eurozone economy will stop the rot. The Euro’s response has been nothing short of a rollercoaster. Its initial plunge was reversed during Mr Draghi’s press conference, and his hints that further interest rate cuts are off the table.

Since QE depends on a cause-and-effect chain of events, there are weak points that can undermine its effectiveness.

The policy has been tried before in the UK, United States and Japan. In the UK and U.S., the policy has been deemed successful; in Japan, however, opinion is fiercely divided. Importantly, though, they were all single markets with a central bank. One difficulty facing the Eurozone is the disparate economic health of the 19 member states, which makes a one-size-fits-all policy approach potentially less effective.

Another potentially significant hurdle is that the ECB will not just be buying directly from financial institutions, but rather from the governments of individual member states. This adds a link to the top of the chain, extending the domino effect needed to push down interest rates and encourage borrowing and spending.

Andrew Sentance, senior economic adviser to PricewaterhouseCoopers, thinks the ECB has left it too late. He points out that the UK and U.S. were much quicker to implement a program, and Japan’s experience in the 1990s suggests that “delaying policy responses allows economic and financial problems to become more deeply embedded.”

Quantitative easing also depends for its success on being able to lower interest rates enough to encourage new borrowing, which can be difficult if rates are low already.