The Take

THE ECB’S BOLD MOVE: LOWER INTEREST RATES AND MORE QE11/02/16

Typewriter Business Correspondent, Zac Brown, and Business Analyst Anton Balint have collaborated on a piece discussing the significant development out of Frankfurt yesterday that the ECB has expanded their unprecedented QE and bond-buying programme as well as cutting key interest rates.

On March 10, 2016, the European Central Bank has decided to further cut interest rates and to expand its quantitative easing in order to revitalize the pale economy of the European Union. The ECB cut its deposit rate to minus 0.4 per cent (10 basis points lower than previously) and ‘encouraged’ the banks to provide credit with cheaper short-term loans and long-term liquidity at negative interest rates (essentially paying the banks operating within the EU to increase credit to businesses and households).

In an act that has been labeled ‘desperate,’ the ECB headed by Mario Draghi has decided to cut rates into the negative while increasing Quantitative Easing. The decision comes after outlooks dropped across the board for all economic indicators, including inflation and GDP for the past two years and more recently domestic consumption. The reaction from markets prior to the meeting was dismal, with the euro plummeting on the EUR/US, the bounce back however was swift and violent.

Italian-born Draghi explained that a possible future cut in interest rates is possible. However, he also acknowledged that this will be a difficult decision to be made as the banks grow worry of the negative interest rates’ impact on their operations.

The ECB’s bond buyback programme has been expanded from €60bn to €80bn and also enlarged the assets it will buy. Moreover, as mentioned above, the ‘Economic Stimulus Campaign’ comes with a plan to provide banks liquidity through targeted longer-term refinancing options at rates as low as minus 0.4 per cent. In effect, the ECB is paying them to borrow money.

Why is this move important?

Firstly, central banks, the European Central Bank included, control the supply of money through interest rates: interest rates are the price of money. Therefore, lower interest rates means businesses and households are finding borrowing cheap. This, in theory should lead to credit creation and boost consumption and investments. On the other hand, the higher interest rates the more attractive saving looks and borrowing ought to decline.

As you can see, interest rates control the amount of credit which is the main driver of consumption: people use credit, in the form of borrowed money (promises to settle a transaction in the future) far more often than cash or other forms of payment settlement. Consequently, the first point is that low interest rates should boost consumption of goods, services and financial assets.

Secondly, low interest rates should make prices of equities (company shares) and real estate (properties) go up. I won’t go into the formulas used to evaluate their prices jump but it is important to understand that investors look to get a return that is always above the free-risk rate which is the central bank’s interest rates (usually on bonds with 10 years maturity). Therefore, the second point is that low interest rates should make investors pay more for equities and property assets.

Finally, interest rates, in theory, have to be responsive to inflation: when inflation grows (this happens when demand for goods and services in the economy exceed supply) interest rates are likely to follow and when inflation slows (this happens because the supply of goods and services in the economy exceed demand) interest rates should go down to boost spending.

Ideally, inflation should stay around 2%. The ECB forecast for 2016 is 0.1%. As a result, the move to lower interest rates further into negative territory is a sign of a strategy to move inflation upwards and balance the economy. Therefore, the third point is that interest rates are a tool of keep the economy on track towards a 2% inflation, which is considered to be a steady balance for economic growth.

We expect high volatility probably to last for a couple of months in markets based in the Eurozone. Draghi has promised that there is almost nothing he considers out of bounds and no measure too radical when it comes to stimulating the economy, in light of his “whatever it takes” speech in 2012, hinting there is nothing he won’t do as ECB Governor to keep the Euro stable.

Understandably, Draghi come under some harsh criticism. Over the past year, negative interest rates have been slowly introduced and have had mixed opinions and reactions. Many experts and speculators simply view it as an act of desperation and causes huge market volatility, like what we have seen recently in Japan, the effectiveness of negative rates can often be very limited.

In this current situation, many are beginning to ask just how much more can the ECB do exactly to stimulate the economy. Rightfully so, if charging businesses and people to keep their money in the bank doesn’t work, what will? What ammunition does the bank have left if another downturn strikes? The ECB is really engaging in the stimulus at a monetary level that European governments should be enacting at a fiscal level – however, these economies are highly leveraged at is, which is another significant problem.

A point being raised is that this over stimulation is simply a breeding ground for inefficiency and makes those within the economy less confident in the methods and plans put in place by the ECB. Given the country has been facing deflation, will more money really solve their current crisis. Traders who have profited and lost alike, ultimately share the same view point: nothing good is going to come of this.