In Mario Draghi’s final policy meeting as European Central Bank President, and after an eight-year term, he continued to approach the current situation of low growth and low inflation expectations as a problem to be solved. In echoes of Draghi’s previous ‘whatever it takes’ policy statement he reminded European leaders that growth and modest inflation (2% target) are key priorities. He deployed strategies to back up his words.
What is being proposed by the ECB?
Quantitative Easing (QE) is back. Starting in November printing more money gets underway. The government will begin buying back bonds at the rate of €20bn a month. Interest rates paid to banks depositing excess reserves with the ECB, currently negative at -0.4%, have been cut to -0.5%. This is designed to force banks to lend, underpinning economic activity. The main Eurozone interest rate remains at 0%.
Critics say that negative rates are now part of the problem. They believe the ‘bang you get for your buck’ is waning, with zero and now negative interest rates hindering income generation. Academics also discuss the possibility that ultra-low rates are becoming a source of uncertainty sending a negative message.
Source: Bloomberg, September 2019
The task of ensuring the smooth running of the Eurozone economy is being handed to the new incoming President of the ECB, Christine Lagarde. She takes up her post in November and inherits the reintroduction of the controversial monetary measure known as QE. She will also note the call to action by Mr Draghi to European governments in charge of fiscal spending. He has urged them to do more to help.
Ms Lagarde must now steer a tricky path. She will have to engage with governments about the need for stimulatory fiscal measures while simultaneously defending a relaxation of monetary policy measures disliked by hawks on the ECB. Hawks worry that QE and negative interest rates are a policy mis-step representing a form of moral hazard. German financiers have fears of hyper inflation embedded in their DNA. Stories, such as the price of a bread loaf in 1935 being equivalent to the entire stock of money in 1928 and prices doubling in a matter of hours, persist.
Economic Growth and Money Expansion:
Other central banks are about to meet. The Bank of England and the Federal Reserve are convening next week, under the same pressure to ease conditions against a backdrop of Brexit uncertainty and trade tensions. Both continue to be headwinds for economic growth.
Policymakers are loath to allow the current economic cycle to grind to a halt. After ten years of lowering interest rates we may, however, be reaching a point of diminishing returns; where the positive effect of further monetary policy action, in its current form, is limited. Households should already be motivated to spend rather than save. Economic growth and ultimately inflation should follow.
But adequate inflation currently remains elusive, particularly within Europe. Compounding this, ongoing US-China trade tensions are having a negative effect on European manufacturing, with recent figures pointing to faltering economic growth.
Clearly, low interest rates are not doing enough to stimulate demand and the underlying causes of slowing growth seem to require a different response. Luckily, policymakers have other tools within their grasp.
Momentum seems to be building behind the prospect of governments harnessing the power of fiscal policy as an alternative. In other words, cutting taxes and increasing government spending to stimulate demand.
President Trump’s tax cuts at the end of 2017 are an example of a strong fiscal response and China is currently promoting a package of similar measures to support growth.
But economies known for their traditional fiscal discipline, best typified by Germany, have been reluctant to join this bandwagon. They are paragons of fiscal restraint and long-time advocates of balanced government budgets. Is this changing? This week the German Finance minister, Oscar Scholz, declared that the German Government could ‘counter an economic crisis with many, many billions of Euros’ should an economic downturn occur: Note that this is reactive rather than proactive.
Taken at face value the comments starkly contrast with Germany’s draconian enforcement of its rigid budget discipline. Governments are now able to borrow at interest rates just above or below 0% which is a bit of a game-changer. Conditions are ripe for such an outlay which could help extend the present economic cycle.
It is often said economic cycles don’t die of old age; rather they expire as a result of policy mis-steps: A case of doing too little or too much. Getting it just right is challenging.
Currently, the judgement by the ECB is that they are doing what they can but they sense governments are doing too little. A big enough fiscal stimulus could put negative yields back into positive territory.
Whether government spending can be deployed in a targeted and effective manner is another matter. We will have to wait to see what transpires next in relation to growth and inflation expectations, both of which need to rise.
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