Today the ECB cut its deposit facility rate again from -0.30% to -0.40%, its fourth 10 bp cut into negative interest rate territory. Since the ECB last eased policy, risks to Eurozone growth have increased to the downside. One only needs to look at the drag on Eurozone growth from weakening net exports. The case for today’s new easing was sealed, we believe, after the January inflation print. Headline CPI fell to -0.2% and core inflation fell from 1.0% to only 0.7%, less than half the ECB’s inflation target. The ECB had to act.
In addition to the rate cut, the ECB expanded its QE programme of purchasing mostly government or government-related bonds by €20 bn, from €60 bn to €80 bn. They expanded the list of eligible purchases to include investment grade euro-denominated bonds issued by euro area non-bank corporates. For banks, a new series of four targeted long term refinancing operations (TLTRO 2), each with a maturity of 4 years, will be launched with the borrowing rate as low as the interest rate on the deposit facility. In other words, subject to conditions, banks can borrow at a rate from 0%, down to a rate as low as the ECB’s -0.40% cost of funds. These conditions will reward banks that increase their lending beyond pre-set benchmarks.
In the near term, we describe these measures as stunningly bold. They have essentially opened up negative borrowing costs to the banks. People had worried about the impact of NIRP as essentially a tax on banks. The ECB has neatly addressed this concern.
Will these measures be enough to stop the decline in longer term inflation expectations, which notwithstanding its recent bounce, have been on a persistent downtrend?
The issues surrounding central banks have recently been less about what they may do and more about whether they are effective, or worse still, whether central banks are running out of ammunition. Yes, they have not been terribly effective if one looks at either inflation or inflation expectations as a gauge of success, although one obviously does not know the counterfactual. In addition, the QE transmission channel through bank lending is difficult when borrowers and lenders both want to delever. But no, we do not believe Central Banks (and policy makers) have run out of ammunition. Just look at today’s list of new policy actions!
What is clear to us is that policy makers must also address the demand side of the economy. The propensity to spend is weak because consumers want to delever, companies are reluctant to invest, and the global backdrop is uncertain (oil and China). If demand is not addressed directly, more of the same (supplying the money markets with even more liquidity) will continue to achieve diminishing returns.
The ECB has said two things recently which would have been quite unthinkable only a couple of years ago. Firstly, they said that “fiscal consolidation should follow a growth-friendly course” (they have learnt the lessons of imposing austerity on Greece to the extent that gdp collapsed and the debt/gdp ratio rose) and additionally, “an environment with a very accommodative monetary policy stance had favourable effects on government budgets and…fiscal policy could play a role in supporting the economic recovery via a growth-friendly composition”. The ECB wants governments with the fiscal space to use fiscal spending to boost growth, whilst they provide monetary accommodation to support that spending.
As investors, we know that fundamentals globally still look quite challenging (low growth, low inflation and leverage in many parts of the world that has increased rather than decreased since the crisis). Government and central bank policy responses will try to sustain what appear to be unsustainable excesses. This can only work if underlying issues are addressed and corrected so that economies can grow without repeated bouts of stimulus. In the meanwhile, we get these repeated bouts of monetary intervention.