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Economic Update


The ECB lowers rates and raises the stakes

September 4, 2014

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Central bank leaders are chosen and coached to be clinical and dispassionate. Their cool, even in the face of challenge, is reassuring to markets.

Perhaps it is the times, and perhaps it is the person. But after presenting a composed façade for months, Mario Draghi did little to hide his sense of urgency today. He announced significant amounts of additional monetary ease for the eurozone and pleaded with European officials to effect structural change with haste. His change of tone may be as important as the messages he shared.

The European Central Bank (ECB) surprised by lowering the refinancing rate at which it lends to institutions to 5 basis points from 15 and increased the charge on deposits left by banks at the ECB to 20 basis points from 10 basis points. Draghi stressed that today’s settings represented the lower bound for ECB interest rates.

While it was not entirely unexpected, Draghi also announced plans for the ECB to begin purchasing asset-backed securities and covered bonds next month. He did share that the decision was not unanimous (a “comfortable majority” was in favor), so it seems as if there was a very active debate. Details about the size and composition of the program will be announced after the next ECB governing council meeting ends on October 2.

The measures announced this morning should help in a couple ways. First, the ECB’s words and deeds have been steering the value of the euro lower throughout much of this year; this helps terms of trade and puts upward pressure on inflation.

And secondly, it is a further step toward reversing the decline in the size of the ECB’s balance sheet, which has been shrinking over the past couple years as the banks redeemed the first round of term refinancing. When quantitative easing is conducted, smaller central bank balance sheets represent monetary contraction.
Interestingly, the next ECB meeting will take place in Italy, which along with France has been holding out against structural reform of work and labor markets. Echoing themes he stressed at the Federal Reserve conference in Jackson Hole, Wyoming, last month, Draghi was very direct in noting that monetary policy would have little ultimate effect in the absence of additional economic flexibility.

When asked whether reform wouldn’t present significant political costs for the countries involved, Draghi correctly noted that stagnant growth and structural unemployment are already presenting tremendous social and economic costs. He repeated his call for pan-eurozone coordination of structural change for the benefit of all members.

We applaud the steps that the ECB took this morning and hope very much that they aren’t too late. Another important curative step comes next month, when Europe’s bank stress test concludes. Hopefully, the reckoning will lead to recapitalization and a renewed flow of credit. The path is clear; the question is how many European leaders are willing to follow.

The opinions expressed herein are those of the author and do not necessarily represent the views of The Northern Trust Company. The Northern Trust Company does not warrant the accuracy or completeness of information contained herein, such information is subject to change and is not intended to influence your investment decisions.