European Central Bank President Mario Draghi may take a giant leap in monetary policy tomorrow for limited economic gain.
ECB officials meeting in Frankfurt will not only take the benchmark interest rate below 1 percent for the first time to a record low of 0.75 percent, they will also cut the deposit rate to zero, according to Bloomberg News surveys of economists. The easing will do little to aid an economy sliding into recession and may fuel speculation about what the ECB can do after its conventional policy options are spent, some economists said.
“It’s a bold move and will lead the ECB into uncharted territory,” said Julian Callow, chief European economist at Barclays Capital in London. “With soaring unemployment and few signs of the economy recovering, some strong monetary medicine is needed. But let’s be honest, a rate cut by itself will not end the recession, we need much more for that.”
Europe’s sovereign debt crisis, which has forced five of the 17 euro nations to seek bailouts, is curbing growth across the continent and damping the global economic outlook. While ECB rate cuts might not stimulate demand, they would lower borrowing costs for troubled banks. They could also build on the confidence boost that euro-area governments provided last week when they took steps toward a deeper economic union.
The ECB will announce its rate decision at 1:45 p.m. in Frankfurt tomorrow. Of 62 economists surveyed by Bloomberg, 46 predicted a quarter-point cut in the benchmark rate, five forecast a half-point reduction and 11 projected no change. In a separate survey of 22 forecasters, 12 said the 0.25 percent deposit rate will be cut to zero, two predicted a reduction to just above zero and eight expected no change.
“A rate cut will have a very, very limited effect on inflation and activity,” said Jens Sondergaard, senior European economist at Nomura International Plc in London, who nevertheless predicts the ECB will lower rates. “You may ask why bother in the first place, but it’s wrong to dismiss rate cuts. They have an important signaling effect, and markets want reassurance that measures are being taken.”
Bond and equity markets rallied last week after euro-area leaders opened the way to recapitalizing banks directly with bailout funds once Europe sets up a single banking supervisor. They also dropped the requirement that taxpayers get preferred creditor status on aid to Spain’s crippled lenders.
Yields on Spanish 10-year bonds fell to 6.25 percent yesterday from 6.94 percent on June 28, while the Italian equivalent dropped to 5.63 percent from 6.19 percent.
Europe’s debt crisis has pushed central banks around the world into action to protect their economies.
The Bank of England last month committed to activate a sterling liquidity facility to aid banks, and economists predict it will expand stimulus further at its policy decision tomorrow. It will increase its target for bond purchases by 50 billion pounds ($78 billion) to 375 billion pounds, according to the median forecast in a survey of 41 economists.
The Federal Reserve said on June 20 it will expand the Operation Twist program to extend the maturities of assets on its balance sheet, a move that will lower longer-term interest rates in financial markets.
Draghi last month questioned the effectiveness of cutting ECB rates, arguing that “price signals” have a “relatively limited immediate effect” amid financial-market tensions.
‘No Inflation Risks’
Since then, the euro-area economic data have deteriorated. Unemployment rose to a record 11.1 percent in May, services and manufacturing output contracted for a fifth month in June and economic confidence slumped to the lowest in more than two and a half years. The euro economy will shrink 0.3 percent this year, according to the European Commission.
While inflation is at 2.4 percent, in breach of the ECB’s 2 percent limit, Draghi said on June 15 that there are “no inflation risks in any euro-area country.”
“The economic case for a 50 basis-point rate cut is pretty watertight, but for now it’s easier to just cut by 25 basis points,” said Ken Wattret, chief euro-area economist at BNP Paribas in London. “That is enough to show you are standing ready to do something. And it will definitely help the banks that have borrowed in the LTRO.”
The ECB has lent banks more than 1 trillion euros ($1.26 trillion) for three years in its so-called Longer Term Refinancing Operations, with the interest determined by the average of the benchmark rate over the period of the loans. Societe Generale SA estimates that cutting the key rate by 50 basis points would save banks 5 billion euros a year.
Cutting the deposit rate may also lower money-market rates and encourage banks to lend to other institutions, companies or households instead of parking excess cash in the ECB’s overnight deposit facility. Almost 800 billion euros is currently being deposited with the ECB each day.
On the other hand, there is a risk that lower money-market rates could hurt banks’ profitability, potentially hampering credit supply to companies and households and reducing banks’ incentive to lend to each other.
The deposit rate has steered market borrowing costs since the ECB started to provide banks with unlimited liquidity after the collapse of Lehman Brothers Holdings Inc. in 2008. That policy removed the need for banks to lend to each other to meet their reserve requirements, pushing down interest rates. The euro overnight index average, or Eonia, stood at 0.33 percent yesterday.
The impact of lower borrowing costs on the economy may be too small for the ECB to expose itself to the perception that it’s rewarding governments for their latest crisis-fighting efforts, said economists at UBS AG in London and Helaba Trust GmbH in Frankfurt, who predict no change in rates.
“We acknowledge that the decision is close, but on balance, given the marginal benefit of a small rate cut and the perception that a rate cut will be interpreted as a quid pro quo for good behavior, the Council will stay on hold,” UBS economists including Amit Kara wrote in a note to clients.
Draghi said after the last policy meeting on June 6, when the ECB kept rates on hold, that “there has never been a quid pro quo between monetary policy and government policy.”
Still, the ECB doesn’t have a compelling reason not to act, said Marco Valli, chief euro-area economist at UniCredit Global Research in Milan. “There is no big reason to hold fire even if the benefit is small,” he said. “To me, having a little benefit is better than having no benefit at all.”
If the ECB moves closer to zero with rates, it may face questions on what else it can do to stimulate the economy.
Elga Bartsch, chief European economist at Morgan Stanley in London, advocates “large scale asset purchases,” while Christian Schulz, senior economist at Berenberg Bank in London, suggests yield caps for “reform-compliant and solvent sovereigns” and another round of “very long-term” loans.
“They will have no more ammunition in terms of their interest-rate weapon,” said Sondergaard at Nomura. “And if we continue to have disinflationary pressures, the question will be: ‘What can you do next?”’
Head Research Department