The president of the European Central Bank (ECB), Mario Draghi, “managed to shock almost everyone” last week, says the FT’s Claire Jones. He cut the ECB’s benchmark interest rate by a quarter of a per cent to 0.25%. Stocks bounced and the euro slid to a seven-week low against the dollar.
Why he acted
The swift response from ‘Super Mario’ came soon on the back of data showing that eurozone inflation had slid to just 0.7%, says Andrew Peaple in The Wall Street Journal. That’s a far cry from the ECB’s target of 2% and suggests that “an institution famed for its inflation-hawkishness is now just as concerned about the spectre of deflation”.
Deflation increases the real value of debt, as loans are fixed in cash terms. So the burden of public, household and corporate debt, already hampering the eurozone economy, would get even heavier.
The impact of this rate cut, however, is questionable. “The monetary plumbing of the eurozone remains blocked,” says the FT. Banks, especially in the stricken periphery, are grappling with losses on loans and remain undercapitalised, so they are loath to pass on the ECB’s cheap lending rates to consumers. And demand isn’t exactly rocketing anyway, as companies and households already owe too much.
Pushing the euro down…
However, the ECB’s “most potent economic tool to help growth and fight the deflation threat”, says Daragh Maher of HSBC, “is the exchange rate”. With exports comprising 42% of GDP, far more than most developed countries or regions, the euro’s level is central to Europe’s competitiveness. And its strength in recent months has made Europe’s exports more expensive and lowered import prices, lowering inflation.
What’s more, the way Europe’s policymakers view the euro has shifted, says Citi’s Steven Englander. They used to be happy with a strengthening currency because it meant investors had become less worried about it breaking up.
But in the past 18 months the immediate danger of the single currency collapsing has passed. Now a weaker currency is good news as it boosts exports.
However, for now, the euro remains at levels “likely to drag on the region’s exports and recovery”, as Capital Economics points out.
The significance of Draghi’s move is that he is showing he is serious about trying to boost the eurozone: the rate cut has been compared to his promise last year that he would buy up unlimited amounts of peripheral bonds to prevent a default.
…and stocks up
Having now apparently embarked on a campaign to lower the euro through looser monetary policy, the ECB could set a negative interest rate on the money that lenders park with the central bank, which could spur lending.
Further liquidity injections in the form of another round of three-year loans for banks may also follow. “It’s a given that in the next six months the ECB will dispense more cheap money,” says Liam Halligan in The Sunday Telegraph.
Further monetary loosening to weaken the euro in Europe might cause “tut-tutting” in Germany, which is always worried about inflation. But exporters in Germany, and all over the continent, “know where their bread is buttered”.
The broader point is that, while in Europe “the funny-money dials have just been turned up”, as Halligan puts it, Britain and America are more likely to reduce the pace of their money-printing programmes.
Last week’s unexpectedly strong payrolls and growth figures in the US have reinforced this impression. More central-bank support bodes well for European stocks compared to their British and US counterparts, and they are also cheaper, as we have regularly pointed out. Super Mario is another reason to stick with European equities.