Today marks the 70th anniversary of D-Day, June 6, 1944. Let’s take a moment to remember and thank the veterans of D-Day and of all America’s wars.
The challenges that modern Europe faces pale compared with those of World War II. But they are daunting nevertheless. This week, the European Central Bank (ECB) declared war on “lowflation.” The ECB acted after months of delay, despite mounting evidence that very low inflation is undermining the euro zone’s fragile economic recovery.
World equity markets extended their recent gains on the news. The major U.S. stock indexes are at all-time peaks. Those in Europe are at multiyear highs. And emerging markets issues also are in rally mode.
Yesterday, the ECB reduced its main lending rate from 0.25 percent to 0.15 percent. The ECB also dropped the rate on commercial-bank deposits parked with the central bank from zero to minus 0.1 percent. In other words, the ECB will charge banks for holding their money.
The purpose of a negative deposit rate is to encourage banks to lend more of their excess cash so that it can find its way into the economy. This is an unprecedented step for a central bank of the ECB’s size. Sweden and Denmark have experimented with negative deposit rates in recent years, with mixed results.
ECB president Mario Draghi also announced other initiatives that are designed to boost lending to businesses, including giving banks access to low-interest-rate loans.
Yesterday’s moves came two days after news that inflation in the 18-nation euro zone weakened to 0.5 percent in May, its lowest level in more than four years and well below the ECB’s target rate of 1.95 percent. And unemployment, at 11.7 percent, is only slightly below the 12 percent peak of a year ago.
Also this week, the ECB presented new inflation and growth forecasts. The central bank’s economists now exp! ect the annual inflation rate for 2014 to come in at 0.7 percent, down from their forecast of 1 percent in March. And they now project that the euro-zone economy will grow by just 1.0 percent this year, compared with their outlook for 1.2 percent in March.
Deflation is extremely difficult to fight, as Japan’s experience of the last 20 years proves. Flat or falling prices make it harder to reduce government and consumer debt, while encouraging consumers and businesses to postpone spending.
The weak European economic recovery, with high unemployment, is contributing to rising political discontent. This was seen in the dramatic voter backlash against mainstream political parties in last month’s elections for the European Parliament. Smaller, nationalist parties came in first in France, Great Britain and Denmark. Among the common themes is a perceived loss of national sovereignty to Europe.
One of the ECB's aims likely is to weaken the euro currency. This would enable exporters in the euro zone to sell their products more cheaply abroad. A weaker euro also tends to push up inflation by raising the prices of imports.
Draghi said the central bank is prepared to take further action, if necessary. "Are we finished? The answer is no. If need be, within our mandate, we aren’t finished here."
With interest rates basically as low as they can go, the next logical step for the ECB would be quantitative easing: purchases of government bonds or other assets in large quantities. This is what the central banks of the US, Japan and Great Britain have done, and their economies are doing better than the euro zone’s.
However, there’s a major difference in Europe: There are no European government bonds. The ECB would have to buy bonds issued by individual European governments. Making the choices would be politically difficult and may not even be allowed under the ECB’s current mandate. And private European debt markets are not as developed as ! those in ! the US.
Some analysts say the ECB probably could buy bonds issued by European government agencies, as well as corporate bonds and bank debt. As always, the support of Germany, the euro zone's largest country and strongest economy, is both essential and uncertain.
Another major obstacle for Europe is that real progress there doesn’t depend on cheap money and asset purchases. What’s necessary is long-overdue, broad economic reform, which currently is politically unacceptable in many cases outside of Germany.
Commercial banks maintain their reserves electronically at a central bank, which pays them an interest rate set by the central bank for reserves on deposit beyond what is needed to meet regulatory requirements. With the ECB’s new negative interest-rate policy (NIRP), banks instead will have to pay the central bank to keep money there.
Time will tell whether this higher cost for banks will give them enough incentive to lend the money out instead, and whether there is much loan demand from businesses and consumers. Also, will banks pass their negative interest rates on to customers? If not, bank profits will suffer. Or banks may pay no interest and charge account-maintenance fees. But then people may withdraw their money, which would mean less available capital to lend.
The big questions: How long will it take for these changes to have an impact? Is this too little, too late? What next?
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