ECB Puts Its Money Where Its Mouth Is--Will It Be Enough?

Morningstar's Bob Johnson sizes up the several stimulus measures announced by the European Central Bank.

Robert Johnson, CFA 09.06.2014
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A couple of weeks ago we got some news on eurozone GDP, which grew 0.2% between the fourth quarter and the first quarter, and you annualize that, it's 0.8%, and that was below expectations. Certainly the U.S. is growing faster, China is growing faster. It's one of the lowest growth rates out there. So, that was a concern.

And there was some fear that it had slowed even more recently. The PMI, the purchasing managers' surveys, for Europe had dropped from 54-55 in January back to the 52 level most recently. That indicator is a little bit more forward-looking. So that means things are going to be a little bit slower even.

And then the third thing, European inflation, came in at 0.5% year-over-year versus 0.7% the previous month. That 0.5% [inflation rate] is not quarter-to-quarter or month-to-month. That's May of last year compared to May of this year; they were only up 0.5% for Europe, and the target is 2%.

Having inflation so low is dangerousbecause you start to build the deflationary expectations, and people hold off buying, thinking it's going to be cheaper tomorrow. It's harder to get rid of it. You have to do all these games--which frankly they started to do already, the negative deposit rates and all the really oddball stuff--and they really would like to avoid that. It's a lot easier to control monetary policy and economic growth when you've got at least a modest bit of inflation. But when you are in deflation, it's hard to fight your way out.

The first measures that ECB implemented, given that backdrop, was cutting a key interest rate - their main lending rate - to 0.15% from 0.25%. 0.25% was already pretty low, but they've moved it even lower.

I'm surprised they haven't brought that rate down sooner. Frankly it's a little bit lower in the U.S. than what it was [in the eurozone]. Now this move brings us a little bit more in line. So that was good to see. And the emergency rate also came down a little bit more drastically from 0.7% to 0.45%.

And then the third component is … banks are paid money when they put money in the central bank usually, and in this case, they're going to charge banks a fee. They're actually going to make it a negative interest rate of 0.1%. The purpose there is to hope that banks will lend the money out rather than having a little bit of it confiscated every year.

I think it could work, although you've got to keep in mind, we are telling the banks to be more cautious with the new Basel III regulations and saying we don't want a repeat of all the old stuff, and yet by doing this, you're certainly going to encourage them to take some riskier loans.

One thing that they still have in the toolbox that they haven't deployed yet is quantitative easing. Last year the strongest statement ECB president Mario Draghi made was, "we will do whatever it takes." This year, "we're not through, yet" is the motto that came out of the press conference that everybody will latch on to. So, I think there is some thought that quantitative easing--which is buying long-term bonds directly--which they've been pretty much opposed to for some time, that they're laying the groundwork to do that. They haven't actually done it.

The other thing they've done shorter-term to improve lending is that they've now got another program where the banks put up collateral, they'll lend them more money, so they can make more loans.

In Europe, banks are much more important to the overall system than they are here in the U.S.--as important as they are here. Here at least we've got a bond market you can go to. You've got a stock market you can go to. You've got an asset-backed security market that's huge. They've got one in Europe; it's a fifth the size of the U.S. market. So you just don't have a lot of alternatives other than the banks.

So certainly to stimulate the banks is important, and this program today will encourage the banks to lend more money. It's $400 billion. It's not a small program. They've tried it before, and it has helped the economy. They hope is that it does so again. And if that doesn't work, then we roll out the big guns, the QE, which is probably the thing that got people most excited.

As you look at the total world economy, certainly by bringing rates down, they join a large crowd already, with China, Japan and the U.S. all already doing extensive measures. So, they're kind of late to join the party.

One of things it will do is bring down the euro exchange rate, and that would be good news for their exporters, but probably less good news for U.S. exporters who will now have to compete against tougher European competitors.

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Robert Johnson, CFA  Robert Johnson, CFA, is director of economic analysis with Morningstar.

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