ECB, big gun but running out of ammunition?

Web Posted on : Mon, 21 Mar 2016


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In response to falling inflation and lagging growth, the European Central Bank (ECB) introduced a range of easing measures on 10 March, cutting interest rates and expanding its quantitative easing (QE) programme. The measures were impressive in scale and scope, but the markets response has still been mixed. This could be due to concerns about how much additional firepower the ECB has left. Monetary policy has done much of the heavy lifting for Europe’s economy during its intermittent recovery from 2009, but, going forward, a more expansionary fiscal policy and structural reforms are needed to boost growth.

The ECB took a number of steps on 10 March. The deposit rate was cut by 10 basis points to -0.4% while other policy rates were cut by 5 basis points. Additionally, the QE programme was expanded in volume (monthly asset purchases were increased by EUR20bn to EUR80bn) and scope (the ECB will now buy investment-grade corporate bonds). Finally, a new series of targeted long-term refinancing operations (TLTROs) was announced. These will give banks access to cheap borrowing, with rates potentially as low as the deposit rate (-0.4%) if banks meet criteria to lend the money on to the economy.

The aim of easier monetary policy was to raise inflation and support growth. The Euro Area fell into deflation in February with year-on-year inflation at -0.2%. This was mainly caused by falling oil prices, which should only have a temporary impact on inflation. However, the ECB expressed concerns that low inflation could become more persistent. It could lead to companies and workers setting lower prices and wages, keeping inflation low and making it difficult for the ECB to meet its 2% inflation target. Additionally, the ECB has downgraded its outlook for growth, mainly on concerns about the slowdown in the global economy.

Euro Area inflation and ECB forecasts

(%)

Sources: ECB forecasts, Haver Analytics and QNB Economics

How successful will the ECB be in meeting its aims? The size and breadth of the package could prove helpful in achieving its targets. But the prospect of further ECB easing seems limited now for four reasons. First, the ECB’s President, Mario Draghi, has stated that no further cuts to interest rates are expected. This is probably to protect banks, whose profitability is negatively impacted by negative rates. Second, the size of the ECB’s asset purchases in relation to GDP is already very large, similar to the Fed’s third QE programme. Third, the QE programme aims to reduce long-term bond yields, but these are already quite low. The German 10-year yield is 0.32% while the Italian yield is 1.37%. Finally, the possibility of introducing another large-scale TLTRO seems remote given that banks are unlikely to take up the full amount offered in the current window.

With the ECB’s monetary firepower waning, the region may need to adopt a more expansionary fiscal policy to support economic recovery in the short term. Fiscal policy could prove far more powerful in boosting aggregate demand than monetary easing in a world with low, even negative, interest rates. For the medium term, structural reforms are needed to raise productivity and increase growth potential. Such policies could include infrastructure spending, training programmes to integrate the influx of refugees into the European labour market and addressing high non-performing loans, which are hampering bank credit growth.

In conclusion, the latest dose of easing from the ECB is sizeable and could prove helpful in raising growth and inflation. However, it also probably signals that the ECB is running out of tools to support the economy. Monetary policy has been helpful, but it cannot cure all economic ills.

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