As has been the case so many times during the Eurozone crisis, all eyes were on the European Central Bank (ECB) to intervene on June 5 following its executive board meeting. Eurozone inflation registered a paltry 0.5 percent in May, a problem for countries with high debt as it makes their debt burdens harder to stabilize.
ECB president Mario Draghi announced a series of measures in an attempt to reverse persistent low inflation. These measures were by the ECB’s standards bold; they would have been unthinkable even two years ago. Here are the three main actions the ECB took, and the possible outcomes of each:
The Action: The ECB cut interest rates even lower
The policy rate was cut 10 basis points to 0.15 percent, which is unlikely to make much difference. More importantly, the central bank cut its deposit rate to negative 0.1 percent. This means that banks will be charged to deposit any excess reserves they hold at the ECB overnight. The idea is that banks will be encouraged to lend the cash rather than holding on to it.
The Outcome: Unfortunately, it is unclear that banks will lend their cash. In Denmark when a negative deposit rate was introduced, banks simply passed the charge to part money with the central bank along to their customers, thereby raising borrowing rates for companies and households. A negative deposit rate could cause the euro to depreciate, which would boost Eurozone exports and make imports more expensive —thereby putting upward pressure on prices. Indeed the euro depreciated immediately after this measure was announced, but regained its value vis-à-vis the U.S. dollar within two hours.
The Action: The ECB tried to boost liquidity
One measure to achieve this was to no longer sterilize the Securities Markets Programme (SMP), which amounts to €164.5bn of mini-QE for the Eurozone. The central bank also offered up to €400 billion in cheap liquidity to banks in the form of targeted long-term refinancing operations (TLTROs), with the stipulation that banks have to hit lending benchmarks after two years or repay the money (if they hit the targets they have four years to repay).
The Outcome: There are a few reasons to suspect the TLTROs won’t be a game changer in the Eurozone. First, banks have been busy paying off three-year LTROs from the ECB, so it is not clear they need more liquidity. Those banks that still have three-year LTRO borrowing from the ECB will have to repay it by January or February 2015. Given that the TLTROs are cheaper than the three-year LTROs and will likely come without any conditionality in the first two years, banks may simply use the TLTROs to roll over their three-year LTRO borrowing. Second, in the run up to an asset quality review and stress test of Eurozone banks, many banks are under pressure to decrease their loan books. Finally, even if the TLTROs incentivize banks to lend more, they may have trouble finding creditworthy businesses that are interested in investing and hiring against a backdrop of very sluggish demand in the Eurozone.
The Action: Mario Draghi indicated that more measures are coming
In addition to announcing “If need be, we are not finished here,” Mr Draghi highlighted that the ECB has accelerated its study on purchasing asset backed securities (ABS). The idea is the ECB could buy ABS from banks and give them cash, which they could then lend.
The Outcome: This would reduce asset risk on bank balance sheets. There are a few problems though. One is that it might be more expensive for banks to sell ABS to the ECB than to take advantage of the ultra-cheap TLTROs. Another problem is that there aren’t many ABS for the ECB to buy. The ECB cannot simply snap its fingers and create a market for ABS. It must first convince the Basel Committee to reduce capital charges for ABS.
Together these measures were bold, but they were probably not bold enough. Mr Draghi has further tools he can use to try to prevent deflation in the eurozone, particularly credit and quantitative easing. Given the ECB’s record of acting too late, such programs may not be enough. Ultimately, it is unrealistic to expect the ECB to fix the Eurozone’s woes. That should be up to the elected national policymakers.