The ECB have a pretty full plate of monetary considerations tomorrow. The Eurozone is tilting back into recession, the third in the space of 5 years. Enforced austerity cuts have hammered consumers and put businesses on the ropes. Monetary conditions are tightening. And the spectre of euro contagion jitters is raising its ugly head again. The simplest thing would be to cut rates. The odds are that it will not happen this week. It would smack of the ECB hitting the political panic button in the wake of the Italian election disaster. If the ECB holds its fire this week, markets should not have too long to wait. Without a doubt, the ECB will cut rates down to 0.5% in the next few months. The economy is a disaster zone and needs much more policy sticky tape. A fresh wave of ECB monetary injection should be one the way soon too. Will this be the real thing this time? Are we now heading for unreconstructed quantitative easing? If so, what will be the trigger?
The ECB have already been doing QE in all but name for the last few years, force-feeding liquidity through to the Eurozone by hook and by crook. Last year’s EUR1Tn LTRO programmes pump-primed a huge amount of extra liquidity into the euro banking system. This was QE by proxy, granting cheap cash hand-outs to Eurozone banks, who funnelled it into distressed high-yield euro government bonds. In other words, the ECB sub-contracted its open market bond buying operations over to the banks. While this helped stave off a deeper financial crisis last year, contagion tail risks still remain acute, especially in the wake of the recent Italian elections.
The ECB’s liquidity injection sorely missed its target for economic reflation by a wide margin. The Eurozone economy remains in deep trouble. Recession is on the cards for the third time in less than five years. Germany also risks getting sucked under again in the downdraught. The contraction in Eurozone bank credit tells a very sorry tale of missed opportunity. The money the ECB ploughed into the banking sector has failed to reach the parts of the Eurozone economy that are crying out for help. Loans to consumers and businesses are shrinking, because the banks are slimming down their balance sheets. Much of the liquidity creation has ended up in the banks for their own precautionary purposes - what Keynes described as a classical liquidity trap. What the Eurozone needs is unrelenting QE and in massive size – just like the Fed, the BOJ and the BOE have pumped into their economies as part of the Big Easy monetary reflation.
The only way for monetary reflation to be more effective is for the ECB to make policy unequivocally clear. A new wave of LTROs needs to start up again, with ultra cheap, ultra long and ultra size liquidity gushing back into the banking system. In other words, flood the economy back to health. The ECB also need to do their own dirty work too and buy bonds for their own account – buy assets and stash them on their own balance sheet. In other words, the ECB should begin QE in earnest. Bundesbank hawks may gripe about inflation risks, but that is the last of their worries right now. The very survival of the Eurozone is the key right now.
The ECB needs to adopt the same kind of clear-speak as the Fed so the markets fully understand the message and intent. Despite Draghi’s improved communication skills, the markets still feel unclear about the ECB’s real purpose. Right now, monetary conditions are tightening again in the Eurozone. The banks are repaying LTRO proceeds and this flow needs to be reversed. The ECB should pressure the banks to on-lend it too. Despite some recent easing, the euro still remains relatively strong, while other nations seem happy to play currency war games. The ECB needs to be a much more unequivocal about the benefits to growth from a more competitive and weaker euro. If the BOE can do it, then why not the ECB?
What might trigger real, unashamed QE? The very survival of the euro area itself could be the catharsis. A groundswell of grass-roots rejection of the old political order, with deepening antipathy to austerity is already taking root in Italy. If Grillo-politics and Grillonomics get a hold in other troubled Eurozone economies, the whole EMU experiment is in trouble. If political rejection of the EMU status quo begins to snowball, the Eurozone risks breaking up. Germany and France will need to take a much more pro-active line in saving the Eurozone’s hide. Eurozone leaders will need to stop any other economy following Greece’s descent into near depression. Spain has already been submerged under six successive quarters of recession. With the Spanish jobless rate at 25% and youth unemployment at 50%, Spain is ripe for growing political dissent. A copy-cat anti-austerity protest movement in Spain would wreak havoc with future EMU expectations.
The ECB can deal with minnows like Greece, Portugal, Ireland and Cyprus, but it cannot contend with the bond behemoths of Italy and Spain going pear-shaped together. If they start to teeter, it would be the bellwether for aggressive QE coming to the rescue. By that time, it will probably be too late and it will be game over for the Eurozone and the euro. Once QE is let out of the gate in big size, the euro will be heading back down to parity again. The market is already starting to get a sniff of sea-change at the ECB. The tide has turned on the euro and a sustained break below USD1.30 should get established as Draghi opens the door for more easing ahead.
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