After the European Central Bank (ECB) cut interest rates into negative territory in June, we asserted that central banks act when expectations miss to the downside. Once again, today was the rule and not the exception. The ECB cut interest rates further, notably lowering the interest rate on the deposit facility to -0.20%. In addition, it announced purchases of private sector asset-backed securities (ABS) and covered bonds. In the midst of markedly below-target inflation, downward revisions to eurozone real GDP growth, and geopolitical tensions in Ukraine, Europe desperately needs a boost. While these measures will help to hold the euro to a more competitive value, they confirm that the eurozone’s growth will not impress in the next 1-3 years.
Is this quantitative easing (QE)?
Any outright central bank purchase of assets, whether government or private sector, constitutes quantitative easing. However, the size and nature of the monetary policy tools announced today will not make up a similar program to that introduced by the United States Federal Reserve in 2012. While the size of the program remains undetermined, ECB President Mario Draghi stated that the central bank’s intention is to restore its balance sheet back up to 2012 levels. This would suggest a ballpark of € 1 trillion in monetary fusions, about half of which could be ABS and bond purchases. Other estimates suggest a much smaller program of around € 100 billion. Compared to monetary infusions of US$ 13 trillion, this program is much more modest, particularly considering that only a small portion of available ABS is built from loans made to the SMEs that constitute the core of European growth.
Why asset purchases?
The ECB is attacking precisely the right eurozone problem: contracting credit. Outright asset purchases, along with the ECB’s previously announced targeted long-term refinancing operations (TLTROs), are intended to improve the flow of credit from banks to the private sector. This year’s rate cuts are designed to encourage banks’ participation in the TLTRO program right away, as opposed to holding out in hopes of further cuts. Within the eurozone’s still fragmented banking sector, this new channel of funding to the private sector is meant to open a new channel of funding to households and businesses, improving their ability to invest in additional capacity, hire more workers, and boost eurozone growth as a whole.
Will this monetary policy work?
The ECB has gone about as far as it can go within the confines of European monetary policy, and it is too little too late. There is no hope for repeating a US-like quantitative easing program, as political opposition to pan-European sovereign bonds is too high. Draghi’s statements today asserted that there is no scope for further rate cuts. And, where further purchases are concerned, the ECB is limited to the highest quality debt, the European market for which is comparatively small and illiquid.
Therefore, although the ECB has taken the right measures, Draghi’s statements encouraging fiscal activity confirm this point: monetary policy in Europe has reached its limits, and it is too little too late. Japan’s failure to act quickly or sufficiently to ease monetary policy during its 1990s recession is a staunch example of what is to come for the eurozone. Deflation is taking a strong hold in many countries, which will cause companies to struggle improving profitability or investing in additional capacity. Demand for products throughout EMEA will remain muted as a result, failing to compensate for a slowdown in major emerging markets such as China and Brazil. We thus are urging our clients actively to manage expectations for growth, which will not improve notably for the next 1-3 years.