The European Central Bank is moving inexorably toward cutting interest rates – and possibly more unorthodox policy measures – as economic conditions continue to deteriorate across the euro zone, inflation remains well below the bank’s target and even Germany, the regional powerhouse, begins to feel the effects of the slump.
The central bank could reduce rates by a modest 25 basis points to 0.5 per cent at its next policy-setting meeting Thursday in Bratislava, according to a slight majority of the 76 analysts polled by Reuters last week. It would mark the first cut by the reluctant bank since July, 2012, despite a deepening recession and soaring unemployment in a large swath of the euro zone.
The caution reflects the ECB’s difficult balancing act of producing a one-size-fits-all monetary policy for both strong economies and those facing deepening recessions and massive unemployment.
“This means on the one hand the lowest possible interest rates for EU crisis countries so that they have access to the urgently needed liquidity,” German Chancellor Angela Merkel said last week in a rare public comment on the bank’s dilemma. “On the other hand, Germany would need a higher interest rate because savings are currently losing value.”
Whether the ECB finally takes the rate plunge this week “is a close call. And it wouldn’t be a surprise one way or the other,” said Ben May, European economist with Capital Economics in London. “But there’s a pretty good chance that we will see one in the near term.”
Weaker than expected German economic soundings – the Ifo index, a closely watched indicator of German business expectations, last week suffered its biggest decline in 11 months – have increased the expectation among currency traders “that the ECB will wake up from its monetary stupor and do something to stimulate the European economy,” Andrew Busch, an independent currency and policy analyst in Chicago, said in a note to clients.
Any reduction in the official refinancing rate would be largely symbolic, as banks already have access to essentially cost-free money and there is little demand for loans. Still, it would send a signal that the ECB, like the Federal Reserve, is committed to keeping monetary policy loose until the euro ship is righted.
It also could steer the central bank closer to the next logical policy move – some form of aggressive quantitative easing or other unconventional measures to spur lending and investment.
But a wave of Fed-type asset purchases “looks exceptionally unlikely,” said Benjamin Reitzes, senior economist at BMO Nesbitt Burns Inc. in Toronto. “I don’t see how they would decide on what to buy or even get the Bundesbankers to go along with buying sovereign debt across the board.”
There is already plenty of demand for low-yielding German government bonds. “And I can’t see German central bankers saying yes to buying Italian, Spanish, Greek … debt,” Mr. Reitzes said.
The German central bank has rejected any such bond purchases to repair what ECB president Mario Draghi has called a broken monetary transmission mechanism that prevents already low ECB borrowing rates from reaching the battered euro-zone countries because of the wide interest-rate spreads between the stronger and weaker members.
“What he’s pointing to is that businesses in Spain or Italy of equal credit quality to one in Germany won’t be able to get the same interest rate,” Mr. Reitzes said.
But in a submission last December to Germany’s Constitutional Court, the Bundesbank declared: “Even though monetary policy is having different effects within the euro area, it is questionable whether these differences constitute a malfunctioning to be addressed by monetary policy.”
The court will hold hearings in June on the legality of German participation in the European Stability Mechanism, as well as ECB policies that go beyond its original narrow mandate.