This week, the European Central Bank (ECB) announced a bigger and broader package of stimulus measures than anyone anticipated. But don’t hold your breath for a material near-term boost to growth or inflation in the region.
Both the scale and scope of the latest policy response demonstrated the determination of Mario Draghi’s ECB to tackle deflation risk in the euro area. Still, the package of rate cuts and bank lending stimulus may not provide the economy with the dynamism that markets crave. And Draghi's efforts to fend off questions about quantitative easing (QE) may prove futile.
Rate Cuts and Excess Reserves
Rate cuts didn’t steal the show. The ECB reduced the refinancing rate and the deposit rate by 10 basis points (b.p.) to 0.15% and –0.10% respectively—toward the lower end of expectations.
However, the ECB bolstered these moves by suspending the sterilization of its Securities Market Programme (SMP), which should push the level of excess reserves back to about €250 billion from €125 billion at present. This injection of extra liquidity should force the overnight lending rate towards—and possibly temporarily below—zero (from 25 b.p. now and 15 b.p. had the sterilization operation not been suspended). Hence, the overall easing is slightly bigger than anticipated.
Will Moves Boost Lending?
But the main news was on lending measures. By unveiling a series of targeted longer-term refinancing operations (TLTROs), the ECB aims to support bank lending to the private nonfinancial sector (excluding housing). The first auctions will take place this September and December, with a maximum drawdown of around €400 billion, followed by six more between March 2015 and June 2016.
Several elements of the ECB plan were surprising. First, markets didn’t expect the suspension of the SMP. Second, the TLTRO program is much bigger than expected. Third, and probably most important, the conditions to access the new facility are much less onerous than expected.
This should encourage take-up at the TLTROs. But it also means the program is less likely to boost lending to the real economy. Why? Because it’s quite possible that banks in Italy and Spain will tap the facility as a convenient way of rolling over some of their soon-to-expire LTRO loans (which currently stand at €187 billion and €161 billion respectively). The sharp rally in peripheral spreads since the ECB’s announcement suggests that’s how the market sees it.
To Zero—but Not Beyond
Meanwhile, Draghi also suggested that interest rates wouldn’t be cut further. So it seems that the ECB has ruled out the possibility of driving the deposit rate deeper into negative territory and pushing the overnight rate below zero.
With that option off the table, what will the ECB will do if inflation continues to undershoot its projections (which were lowered this week and now look more realistic)? Draghi’s responses in this area fell a bit flat and he seemed reluctant to talk about the possibility of quantitative easing (QE). We suspect that the ECB thinks it has done more than enough with yesterday’s “significant” package to take QE off the table—or at least buy it some valuable breathing space. It is not clear that markets share that view.
So our take on yesterday’s announcements is mixed. The overall package clearly exceeded expectations. And, in theory at least, the rate cuts and confirmation that we are now at the lower bound take us yet another step closer to QE.
However, the strong focus on bank lending suggests that the ECB still prefers this channel to support the recovery and ward off deflation over large-scale purchases of sovereign bonds. The problem with this approach is that it is likely to take a long time to bear fruit, especially if it doesn’t help to weaken the euro—almost certainly the quickest way to lift growth and inflation in the euro area. As a result, it probably won’t be long before pressure for a QE program again starts to build.
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