ECB action – what does it all mean?


Global Economy Watch - July 2014

Financialisation: The $9 trillion opportunity and what to do with it

Inflation has been dropping in the Eurozone for some time now. The latest estimate is for Eurozone annual inflation of 0.5% in May, down from 0.7% in April.

At its June monetary policy meeting, the European Central Bank (ECB) introduced a negative deposit rate. This represented a break with “conventional” monetary policy thinking, which held that the so called zero bound provided a floor for policy rates.

So what exactly did Mario Draghi announce?

  • A cut in the main refinancing rate from 0.25% to 0.15%
  • A cut in the rate the ECB pays on commercial bank deposits from zero to -0.1%
  • Introduction of “Targeted Longer-Term Refinancing Operations” (TLTROs)

These TLTROs are designed to allow banks to borrow at very low rates, with the aim of stimulating lending to the real economy. Banks will be able to borrow based on their existing lending to the Eurozone non-financial private sector, but will be expected to meet certain benchmarks for lending.

The three key channels to the real economy

Exchange rate – The euro is likely to weaken making Eurozone exports more competitive in global markets. This could boost stuttering growth, while making imports more expensive and so pushing up inflation.

Bank lending – A negative deposit rate should encourage commercial banks to withdraw their reserves from the ECB and lend to the real economy where they could potentially get greater returns. This trend could be further supported by the provision of up to €4oobn of cheap ECB loans (via TLTROs), which is roughly equivalent to the combined economic output of Ireland and Greece.

Confidence – These measures are a clear indication of the ECB’s commitment to avoid price deflation by using extra-ordinary tools, like negative interest rates, to support growth. Draghi, who has steered market expectations effectively in the past, has attempted a similar move by stating “Are we finished? The answer is no, we aren’t finished here”.

Is it going to work?

The euro has weakened slightly since the announcement, but the longer term impact remains unclear. Some inflation may be imported in the short term, which will reduce real consumer spending power, but exporters may take longer to feel a positive effect.

The newly announced TLTRO loans will be extremely cheap finance i.e. charged at the main refinancing operations rate plus 0.1 percentage points (or 0.25% based on today’s rates) for 4 years. This is expected to allow banks to lend to the real economy even though GDP growth rates remain slow by historical standards.

We think the effects of Draghi’s policies will become clearer once the Asset Quality Reviews (AQRs) of the large Eurozone banks are completed towards the end of the year. Investors, markets and the regulator should then have a clear view on the capacity of commercial banks to lend more.