Markets expect the European Central Bank (ECB) to do something next Thursday. They are looking for a package of measures including a cut in the deposit rate and increased quantitative easing.
It’s easy to see why the ECB needs to act. Next week’s figures are likely to show that industrial production in the region has fallen since last autumn, while inflation – at just 1 per cent – has been stubbornly below the ECB’s target of just under 2 per cent. All this is a sign that policy has been too tight.
Many economists, however, agree that the ECB’s actions are likely to be ineffective, and perhaps even counter-productive. “Monetary policy alone can no longer solve the low-growth-low-inflation problem,” says ING’s Carsten Brzeski. Russell Jones at Llewellyn Consulting likens monetary policy to “pushing on a string”.
One reason for this is that a way in which monetary policy usually works no longer seems so powerful. In the past, lower rates have encouraged companies and consumers to pull forward their spending to a time when it is cheap to finance. But Mr Jones says there is now little pent-up demand for new investments. Weak expected demand and a lack of innovation, among other things, mean that companies won’t invest much even if the cost of capital were lower. What’s more, people expect rates to stay negative for years: the inverted yield curve means that markets expect one-year rates to be minus 0.6 per cent even in five years’ time. If cheap money is here to stay, there’s no rush to take advantage of it.
There’s worse. “In some cases interest rate cuts may reduce aggregate demand,” says Harvard University’s Larry Summers. If we’re not getting a return on our savings, we might reasonably choose to save more to reach our target level of wealth – an especially important consideration for people approaching retirement. Also, negative rates tell people that the ECB is deeply worried about the economy, so they might well think: “If the experts are so pessimistic, I should be borrowing and investing less, not more.”
Such mechanisms can operate even when rates are at normal levels. Negative rates, however, add to these dangers. They are, in effect, a tax on banks: the ECB’s negative deposit rate means banks are being taxed on their deposits with the ECB. This reduces their profits, which in turn makes them less willing to lend. Higher taxes do not stimulate economies.
The ECB’s actions next week are therefore more likely to be a gesture of willing than a genuine stimulus package.
Does this mean nothing can be done to boost the region’s flagging economy? Not necessarily. Eric Lonergan at M&G says that a policy of dual interest rates would work; the ECB could lend to commercial banks at a negative rate while raising the deposit rate. This would restore banks’ profitability and encourage lending. Such a move isn’t as radical as it seems: it would be just a souped-up version of the ECB’s targeted longer-term refinancing operations.
There is, though, a simpler solution – for the high-savings northern countries of the eurozone to significantly relax fiscal policy. Sadly, though, there is little support for this.
What we have here is a generational problem. Senior central bankers, politicians and economists spent their formative years in times of high inflation, high government borrowing and high real interest rates. It is difficult for them (and us) to adjust their thinking to a world in which the opposite is the case.
