posted on 18 March 2016
by Gene D. Balas
What Did the European Central Bank Do?
The European Central Bank - eager to combat too-low inflation - acted decisively March 10 by announcing a package of rate cuts and an increase in its bond purchase program. It pushed its main deposit rate for excess reserves banks hold at the ECB further into negative territory, cutting the rate to -0.4% from -0.3%.
To combat the potential adverse effects from negative rates on banks' financial health, the ECB also announced a package of loans from the ECB to banks in which the ECB could actually pay banks to borrow - provided the banks then lend those funds out - under certain conditions. The ECB also will buy €80 billion per month of Eurozone bonds versus €60 billion previously - and the ECB will now also buy eligible investment grade corporate bonds. (One euro equals about $1.11.)
Stocks in Europe initially surged and the euro plunged, which we might expect. But then a curious thing happened as Mario Draghi, the head of the ECB, spoke: stocks fell and the euro rose (though stocks in both Europe and the U.S. rebounded the next day). The action in the euro was not what was supposed to happen; indeed, a primary (if unstated) goal of enacting such a monetary stimulus program was to cause the euro to fall in value.
Why Did the ECB Take the Action It Did?
A weaker currency would accomplish two key things. First, it would make European exports more competitive abroad and imports more expensive. A weaker euro would thus make European-made goods cheaper to foreign buyers, and would stimulate demand and economic growth, while discouraging competition from imports. But for those goods and services that are imported, they would become more expensive, helping to accomplish the ECB's goal of increasing inflation up to, but not above, 2%.
Inflation in the Eurozone was -0.2% year over year in February, according to Eurostat, and that is certainly a disappointing outcome, especially because it fell from a 0.3% year over year increase in January. More inflation would make existing debts easier to repay, for one, and it would also encourage consumption and investment now, instead of postponing it (or abandoning new investment projects altogether).
Of course, goosing inflation can come from increasing demand for goods and services. That would reduce slack in the economy, as unemployment falls and wages might (hopefully) rise and as spare capacity is eroded. That's why the ECB wants banks to lend, so as to get businesses to invest and consumers to spend. Giving banks free money to lend (and even charging them on certain assets for those funds they stash at the central bank) is one way to motivate banks to push loans on to creditworthy customers.
Why Were the Markets Initially Disappointed?
Eventually, investors realize that central bankers may be pushing on a string. Even if banks want to lend, and loans are cheap, it is beyond anyone's power to force a would-be borrower from taking on a loan. That is particularly the case when confidence is reduced by the same central bank in question.
Indeed, the seeds of the program's disappointment are sown into the policy statement itself. The ECB slashed its forecast for inflation this year - and lowered its projections for 2017 as well. It now expects consumer prices to rise by just 0.1% in 2016, having forecast in December they would rise by 1%, with inflation set to pick up to 1.3% in 2017 and 1.6% in 2018, still below its target of just below 2%.
The ECB also cut its growth forecasts, with Eurozone gross domestic product projected to increase by 1.4% this year and 1.7% next, identical to forecasts by the Organization for Economic Cooperation and Development. That compares to previous projected growth rates of 1.7% and 1.9% respectively.
So, if prices are expected to grow only slowly, and the economy might expand only modestly, what business would want to borrow to expand its operations? Similarly, why would consumers desire to leverage themselves further if their wages may not grow? When policy measures intended to reassure and to encourage consumption and investment are announced at the same time as forecasts that neither goal seems likely, it is easy to see why markets were disappointed.
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