The ECB announced a number of policy changes yesterday. Understandably, most focus was on the cut in the refinancing rate from 0.75% to 0.5%. In addition, the marginal lending rate was cut from 1.5% to 1.0% while the deposit rate was kept at zero. While the decision had little impact on interbank rates, it will reduce the funding costs of banks that access the ECB’s Long Term Refinancing Operation and its Emergency Liquidity Assistance. In the future, the cut in the refinancing rate and the marginal lending rate may act to curb the pace of increase in market rates. In this regard, the announcement that the ECB’s regular weekly and three month refinancing operations will continue to be conducted at fixed rates and at full allotment up to July 2014 was obviously designed to complement today’s cut in the refinancing rate and to provide a measure of comfort in relation to access to ECB funding in the future. In themselves, these actions are unlikely to spark a dramatic change in economic and financial conditions. Although Mr Draghi shared one questioner’s ‘frustration’ at the difficulty in translating lower policy rates into easier credit conditions in the ‘real’ economy, he also expressed confidence that the degree of ‘fragmentation’ that had blocked interbank markets was showing clear signs of diminishing of late.
In justifying yesterday´s decision to cut interest rates, Mr Draghi noted that beyond recent signs of poor economic conditions and easing inflation, two developments strengthened the argument for a policy change. These are accumulating signs that weakness in activity was no longer confined to peripheral economies but was becoming more evident in the Euro area ‘core’ and, importantly, a number of indicators that suggest some easing in financial fragmentation (or an improvement in the functioning of the ECB’s monetary transmission mechanism). In these circumstances, there was an increased justification for a rate cut and an increased likelihood that a policy easing would have its intended impact.
By suggesting that the ECB continues to see risk to the downside for economic activity that ‘in the period ahead, we will monitor very closely all incoming information’ and that the ECB ‘stands ready’ to act further, Mr Draghi’s remarks today struck a somewhat more dovish tone today than might have been anticipated. In part this is because it is clear that the risk around the ECB’s continuing expectation that ‘activity should stabilise and recover gradually in the second half of the year’ are far from symmetrical. Moreover, the continuing weakness of activity is increasing the risk that inflation may threaten to fall below rates consistent with the ECB’s target of an outturn ‘below but close to 2%’.
If we abstract from economic conditions there are three somewhat related obstacles to easier ECB policy. First of all, there is the ECB’s mandate that is somewhat more restrictive than that of many other central banks. Although the Draghi-led ECB has broadened the interpretation of this mandate somewhat in the past year or so, it still remains something of a constraint on ECB policy action. A second difficulty for Mr Draghi and his colleagues (and it should be remembered that there has been a substantial turnover in Governing Council members in the past couple of years) is the structure of the Euro area economy with its overwhelming dependence of bank-based financing. Yet another issue is the heterogeneity of financial markets across the Euro area that for example have made designing a specific instrument to support lending to SMEs (small and medium enterprises) hugely difficult to agree. A final consideration is a cultural dimension to policymaking that is significantly influenced by the historic experience of some key Eurozone countries. In that regard, it was notable that today’s decision to cut policy rates was not unanimous. Instead, Mr Draghi noted that there was ‘a very strong prevailing consensus’ to cut rates and within that number again a prevailing consensus for a 25 basis point reduction.
Taken together these various ‘structural’ restraints mean that ECB policy making must operate between relatively narrow tramlines. If monetary policy leeway is curtailed, what does that imply for fiscal policy? In this context, we think that the tone of Mr Draghi’s comments today in relation to budget policy signal a significant if belated reflection of the risks that an excessive pace of fiscal tightening could have on a fragile Euro area economy. The relevant phrase in the ECB press statement is illuminating in a number of ways,
'In order to bring debt ratios back on a downward path, euro area countries should not unravel their efforts to reduce government budget deficits…’
First of all, the focus on a growing debt/GDP ratio rather than a slightly declining deficit/GDP rate in the past year understates the degree of adjustment that has been implemented in the face of very weak economic conditions. So this wording is very much in line with the traditional hawkishness of ECB pronouncements on fiscal matters. Second, the reference to the average debt ratio for the Euro area as a whole, while appropriate to the ECB’s system-wide competence, ignores potentially critical differences in fiscal space between individual countries. Given the ‘traditional’ nature of these comments, the wording of the final portion of this particular phrase is quite surprising. Simply stating that countries should not ‘unravel’ their earlier efforts seems an unusually limited ambition for the ECB in regard to fiscal goals. Indeed, this particular form of wording could be consistent with no further fiscal adjustment measures in the near term or possibly even some limited stimulus. Our judgement is that this interpretation might go beyond what many on the Governing Council might intend. However, it is entirely consistent with a growing view that where central bank policy rates are around zero, more of the responsibility for responding to very weak economic conditions should fall on the shoulders of fiscal policy. We wonder how much of a change in thinking is developing possibly even subconsciously in Frankfurt and what this might imply for the thrust of budget policy across the Euro area for 2014.