Financial News

  • 5 September 2014, 11:20

Eurozone Teeters As ECB's Bazooka Is Held Back

Only in a 100 metre sprint, a Wall Street Journal correspondent joked on Twitter, does a one-tenth of a unit move normally spark such excitement.

The European Central Bank's shock interest cut today, taking its benchmark policy rate from 0.15% to 0.05%, created drama on currency markets, sending the euro down against the US dollar by almost a full percentage point - a move seldom seen - to its lowest level for 14 months.

As dramatic was the ECB's decision to raise the rate it charges commercial banks to deposit money with it from 0.1% to 0.2%.

This negative deposit rate is aimed at getting commercial banks in the Eurozone to lend money to customers rather than hoard it. It highlights how gravely the ECB now views the chronic state of the Eurozone economy.

The Eurozone, to put it bluntly, is teetering on the brink of a Japanese-style crisis.

Japan is slowly dragging itself out of two decades during which it has suffered deflation, or negative inflation, a sustained period of falling prices.

That might sound good news for shoppers but is, over time, a ghastly phenomenon that strangles confidence and economic activity.

Played out at a national level, it also increases the value of debt, something many highly-indebted Eurozone economies cannot afford.

Deflation raises the risk economies cannot meet interest payments on their debts - the factor that forced Greece, Portugal and Ireland to seek bail-outs from the ECB and the International Monetary Fund.

The ECB knows the Eurozone is not far away from such a crisis. Consumer price inflation in the Eurozone currently stands at just 0.3 per cent but in some Eurozone economies, such as Spain, deflation has already taken hold.

The problem is that today's measures are unlikely to work.

Many economists believe the Eurozone's money transmission mechanism - how interest rate changes by central banks filter through to changes in the real economy - is broken. So cutting rates, on its own, will not be enough.

That is why Mario Draghi, the ECB President, also announced plans to buy asset-backed securities (ABS) and covered bonds issued by Eurozone banks.

These are portfolios of loans like mortgages and credit card debt, that banks normally parcel up and sell on to buyers such as insurance companies and pension funds, and the ECB's purpose in buying them is to deliver more money to the banking sector to be lent elsewhere.

The problem here is that the ABS market in the Eurozone is relatively small and so this action is unlikely to deliver dollops of money to the banking sector in the scale that would be needed to make a difference.

But Mr Draghi did not fire his big bazooka - full-blown Quantitative Easing by the buying of Eurozone government bonds - today.

That would be fiendishly complex, not least because it will require approval from the Germans, who are not keen on the idea. Expect calls for it to increase, though, if today's measures prove unsuccessful.