The European Central Bank is all but certain to approve new stimulus measures on Sept. 12 to boost an ailing economy, but the composition of its package is far from clear as a rift has opened between hawkish northern European policymakers and doves from the south.The following explains the various measures under discussion, highlighting the rationale, costs and benefits.
There appears to be a consensus among policymakers to make this move, but the size of the cut is uncertain.
Reducing the rate at which banks park excess cash at the ECB automatically lowers borrowing costs on a whole range of instruments, giving firms access to cheaper cash. This should then induce them to borrow more to invest, giving the economy a lift, with the ultimate hope that this would boost inflation.
The ECB’s primary mandate is to keep inflation in the euro zone just below 2%, a target it has failed to hit for years despite trillions of euros of stimulus.
Markets are positioned for a cut to -0.6% from -0.4%, but some policymakers in private are arguing for a smaller move so they can maintain some room to cut again, if needed. Deep in negative territory, rates are nearing their effective lower limit, where it’s cheaper for banks to hold cash in a vault. So there is only space for a few more cuts before further reductions cease to make economic sense.
As banks sit on more than a trillion euros of excess liquidity, a deposit rate cut will increase the penalty charge they pay for parking this cash at the ECB.
Since it’s virtually impossible to cut customer deposit rates into negative territory, a rate cut automatically eats into banks’ bottom line, compressing already weak margins.
This is a problem because unlike in the United States, the central bank relies on banks to pass the effect of monetary policy onto the real economy. So a hit to profitability could be counterproductive, forcing banks to cut lending.
To limit the impact, the ECB is expected to introduce a tiered deposit rate, which would exempt banks from part of this cost.
But the ECB can’t completely eliminate this burden as the negative rate creates a ‘hot potato’ effect: forcing banks to lend and pass the liquidity around.
In tiering, the ECB is expected to follow the Swiss model and set the exemption in proportion to mandatory reserves.
However, such a system is complex and difficult to implement, so it is likely to remain in place for an extended period. It will also disproportionately benefit banks in France and Germany. While the benefits will be tangible, it does nothing to solve banks’ broader profitability issues.
Quantitative easing, essentially the purchase of government bonds, is the ECB’s most powerful remaining weapon, so some policymakers argue that it should be preserved for a crisis.
The difficulty with QE is that having bought 2.6 trillion euros of bonds already in previous stimulus campaigns, the ECB is nearing its self-imposed purchase limits. While these limits could be changed, this opens the bank to a fresh legal challenge.
Another issue is effectiveness. With Germany borrowing at -60 basis points for 10 years and even Spain borrowing at close to zero, a further reduction in yields brings limited benefits. It also provides little incentive to governments to reform their budgets if they know their borrowing will be largely absorbed by the central bank.
There may be a bigger benefit in pushing down corporate borrowing costs and the ECB is also expected to include corporate bonds in the asset buys, much like in the previous purchase scheme.The ECB is expected to unveil a “reinforced forward guidance” on interest rates, which should assure markets that rates will stay low for a longer period. The guidance is expected to emphasize the economic conditions needed before rates rise and reduce the emphasis on the expected date of the move.The ECB may grant loans to banks — called targeted longer-term refinancing operations or TLTROs — under even more favorable terms than originally planned. Banks in the TLTRO were expected to borrow at 10 basis points above the deposit rate, i.e. at -0.3%. This could easily be lowered to -0.4% or if the deposit rate is cut, then even lower.
The ECB could consider adding new assets to QE but stocks and bank bonds are controversial and unpopular.
Stock ownership is not widespread in Europe so purchasing equities or ETFs would be seen as helping the rich. And since the ECB supervises banks, buying debt of supervised institutions is seen as a conflict of interest.The ECB could redefine its inflation target, which would mean a de facto increase. The logic is that a new definition would assure markets of the ECB’s commitment to keep policy loose. But changing the target when the ECB can’t even hit the current one could draw criticism and a review of its inflation-targetting mandate is likely to wait until Christine Lagarde, the bank’s new president, takes office.