The European Central Bank took emergency action yesterday to avert the threat of deflation in the eurozone, although it still stopped short of launching the broad-based monetary stimulus scheme that many analysts are convinced will ultimately be needed.
The Frankfurt-based central bank sent a major jolt through markets when it announced, against expectations, that it was slashing its main interest rate by 10 basis points once again to 0.05 per cent, a new record low. The ECB also doubled down on its experiment with negative rates by hiking the levy on commercial banks that park money at the central bank from 0.1 per cent to 0.2 per cent.
In perhaps the most significant move of the day the ECB President, Mario Draghi, announced that the central bank would undertake a programme of purchases of asset-backed securities and covered bonds in order to ease the flow of credit to European households. He said that these purchases would have a “sizeable” effect on the European Bank’s balance sheet.
“A wall of money is heading the way of financial markets, courtesy of Frankfurt,” said Fathom Consulting in a note to its clients.
In response the euro plummeted against the dollar, dropping by almost two cents to a 14-month low of $1.2952 as traders bet on the measures pushing down on the value of the single currency. The pound also gained 1 per cent against the euro, rising to £1.2640. The price of sovereign bonds across the bloc rose, while equities were also boosted. Germany’s DAX index of leading shares rose 1 per cent, while the French CAC posted a 1.6 per cent gain.
Mr Draghi said the stimulus was justified by rising economic risks for the single currency, including slowing private investment and geopolitical risks Yet many economists said still more was likely to be needed to push up the eurozone rate of inflation, specifically a programme of sovereign bond purchases along the lines of those enacted by the US Federal Reserve, the Bank of England and the Bank of Japan.
“At the margin, [this] may have some small positive effect on bank lending and activity and perhaps give the euro another downward nudge,” said Jonathan Loynes of Capital Economics. “But these moves are no substitute for the much more powerful policy action which looks increasingly necessary to prevent a renewed recession.”
Speaking at a news conference, Mr Draghi said that a sovereign bond purchase policy was discussed by the ECB’s council but rejected. “Some of our governing council members were in favour of doing more than I’ve just presented, and some were in favour of doing less. So our proposal strikes the mid-road,” he added.
However, Mr Draghi reiterated his previous promise that if inflation did not look like picking up the ECB would be prepared to sanction other “unconventional instruments”, widely understood to include sovereign bond purchases, commonly known as quantitative easing.
The ECB was forced to downgrade its growth and inflation forecasts for the third time this year. It said that GDP annual growth in 2014 was likely to come in at 0.9 per cent, down from its June estimate of 1 per cent, while it cut its 2014 inflation forecast to just 0.6 per cent.
The rate of inflation has been dropping fast in the eurozone, apparently catching the ECB’s governing council by surprise.
The most recent eurozone inflation reading for the year to August showed consumer prices up by just 0.3 per cent, well below the ECB’s target of just below 2 per cent and the lowest rate of price growth since the great recession of five years ago.
But deflation has already set in for some peripheral member states that are imposing deep austerity and experiencing high rates of unemployment. Consumer prices fell 0.4 per cent year on year in Spain in July and 0.7 per cent in Portugal.
They declined at an annual rate of 0.8 per cent in Greece and were flat in Italy. Prices were up in the two core economies of France and Germany but were still subdued at 0.6 per cent and 0.8 per cent respectively.
Growth has also ground to a halt in the 18 member bloc, with GDP flat-lining in the second quarter of 2014. German GDP contracted by 0.2 per cent while it was zero in France. Italy sank back into recession, with GDP falling by 0.2 per cent. The only relative bright spot was Spain, which posted second-quarter growth of 0.6 per cent.
The International Monetary Fund (IMF), which has been pushing the ECB to adopt a more activist monetary stance praised yesterday’s range of moves by Frankfurt.
“We strongly welcome the measures taken by the ECB, which will help to counteract the dangers posed by an extended period of low inflation” said the IMF’ s managing director Christine Lagarde.
Explainer: What the ECB is doing
Q. What are asset-backed securities and covered bonds?
A. Asset-backed securities are bundles of loans packaged up into tradable securities. They pay a relatively attractive interest rate because of the risk that some of the underlying borrowers may not be able to repay their loans. But the interest rate is lower than it would be on the individual loan on the basis that while some of the underlying borrowers are likely to default it is unlikely all of them will. The usual buyers are pension funds and insurers. Covered bonds are similar to asset-backed securities, except they are generally held by banks, rather than institutional investors.
Q. Why is the ECB buying them?
A. The hope is that the purchases will push up the value of the securities and thus lower the yield, or effective interest rate, paid on them. The idea is that the effects of this intervention will ripple out through the financial markets, lower the borrowing costs of households and firms, encouraging them to spend. The institutions that sell the ABSs to the ECB will also have to invest the money, which should boost asset prices.
Q. How much is the ECB buying?
A. Mario Draghi did not specify but sources told Reuters that the purchases could amount to €500bn over three years. That’s around 5 per cent of the eurozone’s annual GDP.
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