The European Central Bank has lagged behind both the U.S. and Japanese counterparts in their efforts to stimulate the economies of the European Union. Today, they attempted to address that fault before Europe sinks into a recession.
Both bond and stock market investors have been anticipating additional stimulus for several weeks. ECB President Mario Draghi did not disappoint. He said the bank would begin purchasing asset-backed securities and covered bonds, which are investments based on loans to corporations and residential mortgages. The hope is that others will now also jump on board and buy them too.
If that occurs, then European banks would have the courage to make more such loans knowing that the central bank and others would be there to buy them. The thinking is that if it worked in the U.S., it should probably work in Europe.
The ECB also cut its benchmark interest rate to just 0.05% and the deposit rate (what European banks pay to keep their money in the ECB) to minus 0.2%.They stopped short, however, of actually buying government debt, at least for now.
The ECB reduced its forecast for economic growth this year to just 0.9% while lowering its inflation expectations to 0.6%. Some economists think that is still too optimistic. As of August, the EU’s inflation rate was 0.3%, far below the targeted rate of just under 2%.
The ECB has only one job and that is to manage inflation. A slide in inflation (0 or below) can be just as bad as an inflation rate rise. Deflation, rather than inflation, appears to be the greatest fear of officials in the EU. In a deflationary economy, it becomes much more difficult for governments, businesses and consumers to service their debt payments. Investment falls and so does spending. This downward spiral becomes extremely difficult to break.
Japan is a text book case of what happens to a country caught in this kind of cycle. For over 20 years Japan has suffered from low to negative growth, falling exports, declining wages and jobs and negative interest rates. It has taken massive amounts of monetary stimulus, combined with government spending to break out of this cycle and the jury is still out on whether they will succeed.
The European Community, however, is a union of competing interests and it is difficult to arrive at a consensus among 18 members. It is one reason why the ECB has lagged behind its brethren banks around the world in supporting its economies. Although the ECB has conducted a low-interest rate policy, it has stopped short of more aggressive programs such as employing their balance sheet to buy vast amounts of debt in the financial markets. However, today it appears European officials have reached a moment of truth. Cutting interest rates alone has not been able to turn around the situation so even the foot draggers among the EU have finally agreed to more drastic measures.
Most observers would agree that Germany has been the loudest voice in opposing any bond buying actions by the ECB. However, today’s actions set the stage for even more stimulus in the months ahead. Let’s hope it works.