Mario Draghi is betting that the banking system, rather than the bond market, is his best ally for now in the fight against deflation.
Acting in a more sweeping fashion than most investors anticipated, the European Central Bank (ECB) today cut interest rates to unprecedented lows, and its president unveiled measures to beef up lending for banks in a bid to revive inflation languishing at close to a quarter of his target.
With the policy toolbox now virtually exhausted and much hinging on whether banks boost credit themselves, failure to spur consumer prices will leave Draghi with little option but to enter the uncharted terrain of U.S.-style bond buying. Some executives have more hope than confidence that Draghi’s current plan will work.
“We’ll have to see if it comes true, and there is cause for skepticism,” Andreu Antonell, managing director of Macsa Id SA, a barcoding machine maker with 110 employees based near Barcelona, said in a telephone interview. “We’ll have to see if it’s really possible to force financial markets to pass this money on to companies.”
Battling a deteriorating economic outlook and prolonged period of slow inflation, the ECB became the first major central bank to charge—rather than pay—banks for parking cash in its coffers.
It created a targeted 400-billion-euro (US$542 billion) loan program to incentivize banks to lend themselves and extended the practice of granting them as much cheap cash as they want until the end of 2016. It also suspended the sterilization of crisis-era bond purchases to raise liquidity in money markets.
“Taken together, the innovative and comprehensive bundle of measures will support the economic recovery over time, and it certainly will not do any damage,” said Holger Schmieding, chief economist at Berenberg Bank in London.
The ECB will now seek time to assess the impact of its new policy measures, making it “less likely” it will embark on any quantitative easing imminently, said Ken Wattret, chief euro-area economist at BNP Paribas SA, who had predicted asset purchases would begin in the third quarter.
The new loan program—which is tied to passing on the money to companies and households—won’t begin until September, with another round in December, allowing Draghi to signal it may take three to four quarters to gauge its effect.
That still won’t be enough in the eyes of economists at HSBC Holdings Plc, who forecast the ECB will start bolstering the money supply, and thus inflation, by buying securities including government bonds sometime next year. David Owen, chief financial economist at Jefferies International Ltd., said the bank might be forced to unveil that measure as soon as December.
By contrast, Azad Zangana of Schroder Investment Management Ltd. predicts that the ECB will start by then with only “very small” purchases of asset-backed securities (ABS).
Conceding that rates are now at the lower bound “for all practical purposes,” Draghi signalled policy makers are willing to act again if needed and said they are studying how to do so. Officials could buy “simple and transparent” securities backed by loans to companies—a measure which would require a regulatory overhaul to permit such instruments, he said.
“We think it’s a significant package,” he told reporters in Frankfurt. “Are we finished? The answer is no.”
Such a posture is in keeping with Draghi’s bias toward action, which was most evident almost two years ago with his pledge to “do whatever it takes” to protect the single currency from the regional debt turmoil. It also leaves the ECB injecting fresh stimulus at a time when the Federal Reserve and Bank of England are moving toward withdrawing it.
A full-blown program of quantitative easing with sovereign-bond purchases that those central banks previously implemented might be even thornier for the ECB to contemplate than just ABS buying, as the euro region lacks a unified government debt market that would be its obvious target.
It would also be politically charged amid questions—especially in Germany—over whether the ECB has the authority to buy sovereign debt and could flop given government bond yields are already at record lows.
Whether quantitative easing (QE) can be avoided may well depend on how banks react to the latest provision of aid. The negative deposit rate is aimed at stemming unwarranted increases in money-market rates and weakening the euro, yet could backfire if banks retrench further or pass the cost on to customers. Low interest rates and repeated loans to banks also have failed to spark credit, especially in the crisis-hit southern parts of the continent.
That might mean that Draghi ultimately has no choice but to engage fully with QE.
Policy makers will “want to see this broad package of measures as a QE firebreak,” said Richard Barwell, senior European economist at Royal Bank of Scotland Group Plc. “Expectations of a broad-based asset purchase program will rapidly start to build.”